ECON

WEEK 1
Economics and Scarcity

Let’s begin by discussing scarcity. Resources (land, labor, factory buildings, timber, minerals, machinery,
and the like) are the basis for producing the food, shelter, medical care, and luxury goods that we want.
Some of these are natural resources (land and timber), some are capital goods resources (factories and
machinery) and some are human resources (labor).
These resources are scarce in the sense that there are not enough of them to produce everything we
need and desire. Even when using all resources as efficiently and completely as possible, and using all
modern technology to its fullest extent, there is some limit to the amount we can currently produce.
Scarcity forces us to choose among competing uses for society’s resources. What to produce and how to
distribute this output to society’s citizens are the most basic economic choices to be made.

The easiest way to think about the problem of societal choice is by looking at a basic economic concept
and graph called production possibilities. Production possibilities shows the maximum amounts of two
different goods that can, possibly be produced during any particular time period using society’s scarce
resources. Because reality is complex, economists try to simplify it by making assumptions about the
basic elements involved in analyzing an issue. In examining production possibilities, we must make these
simplifying assumptions about our economy:

1. All available resources are used fully.

2. All available resources are used efficiently.
3. The quantity and quality of available resources are not changing during our period of analysis.
4. Technology is not changing during our period of analysis.
5. We can produce only two goods with our available resources and technology.

Let’s consider the implications of these simplifying assumptions.

• First, all available resources are used fully, so that no workers are unemployed, no factory
buildings sit idle, and so forth. (This does not mean that we fail to conserve some of our resources
for the future. If we think that the habitat of the snowy owl is important ecologically, we simply
do not make that part of the available resources.).
• Second, efficiency means that we use our knowledge and technology to produce the maximum
amount of output with these resources. These first two assumptions mean that our economy is
doing the best that it can; it is operating fully and efficiently.
• Third, the quantity and quality of our resources are not changing. This means that over the current
time period, workers do not begin new training programs to make them more productive, new
natural resources are not discovered, and so on.
• Fourth, technological change-which might give us a better means of producing more goods with
the same resources-is not occurring. We make these last two assumptions to deal with the world
as it is right now, and not how it might become in the future. And finally, to simplify our analysis
(and because here we graph in only two dimensions), we assume that we can produce only two
goods with our resources. Let’s pick bread and roses as the goods.
One of our choices is to put all of our resources and technology into the production of bread. This choice
might give us 150 units of bread. Whether these bread units are loaves, cases, truckloads, or tons is
irrelevant here. Let’s suppose they are tons.

Two old adages suggest that man (and woman) cannot live by bread alone and that life is richer if we
stop and smell the roses. So, let’s allow another choice and take some resources and some technology
out of bread production and use them to produce roses. Now, we might end up with 20 units of roses
and only 120 tons of bread. Again, the nature of the units is irrelevant; our rose units might be
bouquets, boxes, truckloads, or tons. Let’s suppose they are tons. (Note, however, that we had to give
up 30 tons of bread production to produce the 20 tons of roses.)

Another alternative might be to give up even more bread, leaving us with bread production of only 90
tons, to produce 40 tons of roses. (Note that, once again, we had to give up 30 tons of bread production
to get the additional 20 tons of roses.) The alternatives could go on and on and might be summarized in
a production possibilities table such as Table 1.1. Note that each alternative A through F represents one
possible combination of bread and roses that we could produce.

The information in Table 1.1 can be easily displayed in a production possibilities curve, or graph. Don’t
let graphs intimidate you. They can be very useful. Every graph has just two axes, and each axis shows
the amounts of one variable. As you move along the axes away from the origin, the amounts of the
variables increase. In Figure 1.1, the horizontal axis represents tons of roses, and the vertical axis
represents tons of bread. Each point in the graph represents a row in the table, and the labelling of the
points corresponds to the alternatives in the table. Connecting all points gives us a production
possibilities curve, which shows the alternative combinations of maximum quantities of bread and roses
that our country is capable of producing. (Even though we end up with a straight line, we still call it a
production possibilities curve).

A number of important concepts are illustrated by the production possibilities curve. These
are the following:
 Note: the handwritten reads this way:

There is some limit to what we can produce.

• to produce more of one good, we must give up

production of something else.
• Opportunity cost is the best alternative that is forgoneto
produce or consume something else.

“There is an opportunity cost to everything”.

The opportunity cost of producing roses is not measured in

dollars but in the bread that we give up when we produce
these roses. And the opportunity cost of producing bread is
the roses we give up when we produce this bread. As
economists are fond of saying, there is no free lunch!

Unemployment - In reality, some resources may go unused

factories are idle and workers are laid off.Nor do we always
use resources in the most efficient manner.
In these cases, we will not be on the production possibilities curve, but at some point, below it,
such as U (representing unemployment) in Figure 1.1. At point U, we are producing only 40 tons of roses
and 60 tons of bread, though we could produce more of both if we had full employment. Clearly, we
could do much better by putting idle resources to work and moving our way back out to the production
possibilities curve.
Economic growth - occurs if the quality or quantity of society’s resources increases

• Our country need not be restricted to a single production possibilities curve forever. Economies
may grow and the resources certainly do change over time.

Such a shift would enable us to move to a point such as point G (representing growth) on the new
production possibilities curve. Clearly, point G (with 80 tons of roses and 90 tons of bread) is superior to
a point such as D (with 60 tons of roses and only 60 tons of bread) on the original curve. Such growth is
possible only over time, and not in the current time period illustrated by the first production possibilities
curve.

Of course, our country and world are capable of producing more than just two goods. We produce
trucks, spaghetti, gasoline, smart phones, swimming suits, and a bewildering array of merchandise that
fills our shopping centers. We also produce services such as health care, education, road repair, and
cellular phone service. We can easily imagine infinite combinations of all the goods and services that an
economy can potentially produce. We cannot graph these infinite combinations, however, because our
graphs have only two axes. So, bread and roses simply represent one of an infinite set of choices. We
can make our graph a bit more realistic by redefining the axes. We might redefine the horizontal axis as
staple goods and the vertical axis as luxury goods. Or we could divide our economy’s output into
agricultural goods and manufactured goods, or consumer goods (goods that are purchased by
consumers) and capital goods (goods such as factory buildings and machinery that are used to produce
other goods). We may examine the choice between military goods and civilian ' goods. Or we may look
at the production possibilities for private goods (such as cell phones and hamburgers, which are
provided by businesses) and public goods (such as police and the protection, which are provided by
government). Thus, we can realistically consider many choices involved in the production of various
types of output.

The production possibilities curve also helps us realize that the costs of unemployment are not limited
to personal hardships experienced by the unemployed person and his or her family, although these
personal costs may be severe. Costs are also borne by our nation and our world as a whole 1n the form
of reduced production. If we waste our resources through inefficient production techniques, output is
similarly reduced. In a world of scarcity, we must see to it that our resources are fully and efficiently
employed in the present, and we can then seek to expand our productive potential in the future.

And the problem of scarcity is real. Worldwide, more than 22,000 children die every day from poverty-
related causes. Many of the world’s citizens lack basic nutrition, health .care, education, shelter;
clothing, clean water, and hygiene. Many of the world’s nations lack basic infrastructure in the form of
communications, transportation, sanitation, and electricity. Any time a poor country makes a decision to
improve transportation, for example, as an investment in the future, many of its citizens may die of
hunger in the present. Even in a prosperous country, some 15 percent of the population is poor. As we
shall see in later chapters, these people do not receive adequate food, shelter, health care, clothing, and
other necessities.
Economics and Distribution

Although production choices are important, they really tell us only half of the story. At least as
important are choices relating to the distribution of goods and services. The reason there is hunger in a
world of plenty is not a problem of production but of distribution. Poor people and poor governments
lack the income to purchase the food that is produced. In terms of our current example, who should
receive the bread and roses after they are produced? Should the decision be based on equality so that
everyone receives the same amount of every good that everyone else does? Should people receive a
share of the goods and services that is proportional t6 their contribution to producing those goods and
services? Should the government make the distribution decisions, perhaps giving higher rations to those
most “deserving" (however that might be determined)? Should the government ensure that all
residents receive adequate housing, health care, nutrition, and education, with less-vital goods
distributed on the basis of people’s incomes and desires? Should all goods and services be distributed
on the basis of people’s incomes? On what basis should distribution choices be made?

As we will see, in a market-based economy such as ours, the choices of distribution as well as
production are based primarily on prices. And prices are determined by demand and supply.
Demand and Supply Demand

Have you ever had to hire a tutor to help with your coursework? (I hope you haven’t had to in
economics, at least not yet!) What are some of the factors that would determine the number of tutoring
hours you would wish to purchase? Probably the degree of difficulty of the coursework is important,
and so is your income, which will determine how much tutoring you can afford. Most likely, the price of
tutoring services is important to you as well. All other things being equal, you would probably be
inclined to purchase more tutoring service hours at $1 per hour than at $5 per hour. Most of us tend to
behave in the same way. At very high prices, we would tend to be frugal in our use of tutoring services.
We would ask more questions in class, study with a friend, or visit the teacher during office hours
(maybe bringing along an apple or two). We would perhaps study harder (or take the consequences)
rather than pay the fee for many hours of tutoring services if the price is high. At lower prices, we would
be willing and able to purchase more hours of tutoring. Let’s focus on the price variable for a moment.

Let’s assume that you attend a large university where there are many students who want tutors as well
as many students willing and able to tutor. Suppose we consider all your school’s students and their
desire to purchase tutoring services. Let’s assume that the time period is one week and that all factors
other than price (such as course difficulty and student income) are held constant. (Economists usually
say “all other things equal” to specify that all other factors that might influence the quantity demanded
are unchanging.)

To illustrate this example further, let’s put this information into a tabular format. Let’s consider people’s
willingness to buy tutoring services, where P stands for alternative possible prices of tutoring services
and QD (quantity demanded) stands for the amounts of tutoring that students are willing and able to
purchase at these various prices. This is reflected in Table 1.2, which shows alternative prices and the
quantities that people are willing and able to purchase at these prices. This is called a demand schedule.
It is clear that if tutoring prices are low (say, $2 per hour), the quantity demanded will be high (80
hours). If tutoring prices are higher ($4 per hour), the quantity demanded will be lower (40 hours). This
simple common sense idea that people will be willing and able to buy more of a good or service at low
prices than at high prices is a fundamental economic principle, the law of demand, which is usually
stated as follows: price and quantity demanded are negatively related, all other things equal. This
means that when price goes up, quantity demanded goes down, and vice versa.

We can place the information from

Table 1.2 into a graph of demand,
illustrated in Figure 1.3. A graph of
demand is referred to as a demand
curve (even though demand curves
are often drawn as straight lines). The
price of tutoring services (P) is on the
vertical axis, and the quantity of
services demanded (number of
hours) is on the horizontal axis, which
is labelled Q for quantity. Plotting the information in each of the rows a
 through e in the table gives us points a through e in the graph. Connecting these points gives us the
demand curve in Figure 1.3. The demand curve (labelled D for demand) indicates all possible
combinations of alternative prices and quantity demanded, assuming that all factors except price that
could affect quantity demanded are held constant.

Note that the demand curve is downward sloping, reflecting the

law of demand. A higher price is associated with a lower quantity
demanded (40 hours at $4 per hour), whereas a lower price is
associated with a larger quantity demanded (80 hours at $2 per

What if one of the other factors affecting demand was to change

Course difficulty might increase, for example. Or student incomes
might increase, making students better able to afford tutoring.
hour).
Each of these examples would increase the demand for tutoring services. You probably can add to the
list of things that would increase the demand for tutoring.

An increase in the demand for tutoring services will result in an

entirely new demand schedule, such as the one in Table 1.3. We can
plot this new information in the same graph as before, and we end up
with an entirely new demand curve, D’. (See Figure 1.3.) Demand has
increased so the demand curve has shifted forward, or to the right.
Note that for every price that existed before, a higher quantity
demanded now exists.

Supply

Now let’s consider the other side of the market for tutoring services, the supply side. Imagine the
students at your school who not only don’t need tutoring but who are actually able to tutor. This is the
group of students who might supply tutoring services for a fee. What are the factors that influence
these students’ willingness to offer their tutoring services for sale? Probably the costs associated with
providing the service are important. The most obvious cost is the value of the tutor’s time. Remember
that opportunity costs are always important. The opportunity costs Of a tutor’s time may be quantified
easily if an adult tutor hires a babysitter while he or she tutors or if the tutor forgoes income from
alternative employment. Some costs that are less easy to quantify are just as real. The tutor might be
giving up precious study time, quality time with friends and family, or simply valued leisure time.
Although it’s hard to attach a dollar value to these costs, they remain important. Remember that there is
no free lunch; every choice has an opportunity cost; every activity chosen entails another activity given
up.
Another factor affecting the total quantity of tutoring services supplied will be the number of ~ tutors
available. If we experience an increase in enrolment of top-notch students who are dying to become
tutors, we can expect more tutoring services suddenly to be supplied.

The price that tutors can receive for their services will also be an important determinant of their
willingness to supply these services. Let’s focus our attention on this price variable for a moment. Let’s
look at the supply of tutoring services in a one-week time period, when all the factors except price that
might affect the number of tutoring hours supplied are held constant. It is realistic to assume that
individual tutors will be more willing to provide tutoring services at a high price than at a low price. The
higher price will allow them to cover their babysitting expenses more easily or will serve as a stronger
inducement to give up leisure or time with friends and family. It will compensate them better for other
job prospects they don’t pursue because they are tutoring. In simple terms, the higher the price, the
greater the incentive to provide tutoring services. Tutors (and business firms) will offer for sale a larger
amount of the good or service at higher prices rather than at lower prices.

This is known as the law of supply, which is usually stated as follows: price and quantity supplied are
positively related, all other things equal. This simply means that price and quantity supplied (the
amount offered for sale) change in the same direction. If price goes up, so does quantity supplied; if
price goes down, so does quantity supply.
The behavior of all tutors as a group might be summarized in Table 1.4, which is a supply schedule
showing different quantities of tutoring hours supplied (Q3) at the alternative prices (P) that the tutors
might receive. The quantities represent the total number of hours supplied by the group as a whole at
each alternative price over the specified one week time period All the factors other than price that
might affect the tutors’ willingness to tutor do not change. Thus, the only thing changing is the price
determinant.

We can place the information from the supply schedule in Table 1.4 into a graph of supply, or a supply
curve in Figure 1.5. The axes are identical to those in the demand graphs, with price on the vertical axis
and quantity on the horizontal axis. Plotting the information in each of the rows V through Z gives us
points V through Z on the graph. Connecting these points gives us the supply curve 5 in Figure 1.5.

Table 1.4 Figure 1.5. Supply Curve for Tutoring Services, One
Week
The graph shows amounts of tutoring supplied at various prices.
The supply curve indicates all possible combinations of quantity supplied and alternative prices with the
assumption that all other factors affecting supply are held constant. Note that the supply curve is
upward sloping, reflecting the law of supply: price and quantity supplied increase together.

What if one of the other factors affecting supply was to change? Babysitting costs might decrease so
that some tutors would be more willing to provide tutoring services, for example. This would increase
the supply of tutoring services. You can probably list other factors that would increase the supply of
tutoring. Changes in the costs of producing or supplying a product are among the most important
factors causing a shift in the supply curve.

An increase in the supply of tutoring services as a result of

lower babysitting costs will result in an entirely new supply
schedule, such as the one shown in Table 1.5. Note that for
each price, a larger quantity supplied now exists.

If we plot this new information on the same graph as the

original supply curve, we have an. entirely new supply
curve 8’, as indicated in Figure 1.6. Supply has increased,
and the supply curve has shifted forward, or to the right,
showing increased quantities supplied at each of the given
prices. Lower costs always cause a forward shift in the
curve, whereas higher costs always cause a backward shift
in the curve.

Putting Demand and Supply Together

We can now consider the entire market for tutoring services at your school for the time period of one
week. We have a demand schedule (or curve) that reflects the buyers’ (students’) attitudes toward
purchasing tutoring services. And we have a supply schedule (or curve) that reflects the sellers’ (tutors’)
attitudes toward supplying tutoring services. We simply have to put demand and supply together. Let’s
put them together graphically first. We will consider the original demand curve D and the original supply
curve S, which are shown together in Figure 1.7.

Figure 1.7 Market for Tutoring Services, One Week

The market will clear at point E. At $3, quantity demanded equals quantity supplied
 As you can see, there is only one point in the
graph (point B) where quantity demanded
(which we read off the demand curve D) is
equal to quantity supplied (which we read off
the supply curve S). This point occurs at the
intersection of demand and supply and
corresponds to a price of $3 and quantities
demanded and supplied of 60 hours a week.
At point B, the market for tutoring services is
in equilibrium, or a state of balance, because
the amount of tutoring services that students
are willing and able to purchase is identical to
the amount that tutors are willing to provide. This equilibrium can also be seen in Table 1.6, which
shows the original supply and demand schedules and (in bold) the equilibrium price and quantity.

The market for tutoring services naturally tends to move toward the equilibrium point. To illustrate this
tendency, consider what would happen if tutors were charging less than the equilibrium price of $3 an
hour. Suppose that the tutors were charging only $1 an hour. At $1, the quantity demanded (100)
exceeds the quantity supplied (20) by 80 hours. There would be a shortage of tutoring services of 80
hours, because at $1, buyers regard tutoring as a bargain, whereas sellers have little incentive to
provide tutoring. (Note that in a technical sense, shortages only occur when market prices are below the
equilibrium price.) Students will bid for the tutoring services that are available, and in the process the
price will be bid up. Put yourself in the position of a student who needs tutoring. You would quite likely
offer slightly more than $1 to a tutor so that you would receive the tutoring instead of your friend. Your
(former) friend would probably be trying to do the same. In this process, the average price of tutoring
would be pushed up. The bidding up of the price will continue only as long as the shortage exists, and as
the price rises, the shortage will disappear. Two things happen as price increases: (1) buyers decrease
the quantity they demand, and (2) sellers increase the quantity they offer for sale. This process of rising
price, decreasing quantity demanded, and increasing quantity supplied is shown in Figure 1.8. The
process will come to a screeching halt when equilibrium is reached at point B. Because the shortage no
longer exists, the price will rise no higher. Economists usually refer to this phenomenon as the rationing
function of price. This means that the movement of the price has ultimately rationed away the shortage.
Without the ability of prices to adjust by moving upward, the shortage would have persisted
indefinitely. Socialist countries have often done just that-they have prohibited prices from adjusting
upward. As a result, shortages have been commonplace.

Now consider the opposite possibility. Tutors might be charging a price-say, $5 -that is above the
equilibrium price. Perhaps they feel that they can make a lot' of income at this high price. There is,
however, a problem in the market at this price. At $5 an hour, the quantity (20 hours per week) of
tutoring services demanded will be very small. But tutors will be willing to supply a large quantity (100
hours per week) because they have so much incentive. The difference between the quantity that tutors
supply and the amount that students actually buy (quantity demanded) is a surplus of unsold services in
the market. (Note again that in a technical sense, surpluses only occur when market prices are above
the equilibrium price.) Surpluses cause the price to fall. Tutors will undercut one another’s price to get
some business, and the price will fall until it reaches the $3 equilibrium. As the price decreases, quantity
demanded will increase, quantity supplied will decrease, and the surplus will disappear. This process is
illustrated in Figure 1.9. The process comes to a halt when equilibrium is reached. The falling price has
rationed away the surplus.

Figure 1.9 Response to a Surplus of Tutoring Services

Shifts in Demand and Supply

The market for tutoring services will remain in equilibrium at point B unless some other factor affecting
the market changes. Because things rarely remain unchanged, it is important to consider what might
happen if the variables affecting either the demand for or the supply of tutoring services were to
change.

Consider our earlier example in which an increase in student incomes caused an increase in the demand
for tutoring services. The only thing that we are doing differently now is considering this shift in demand
in the context of demand, supply, and equilibrium. The demand curve will shift forward to D ’, as
illustrated in Figure 1.10. Figure 1.10 Effects of Increased Demand for Tutoring Services

Note that the supply curve will not shift. The

old demand curve D’ becomes irrelevant, and
a new equilibrium E exists at the intersection
of the new demand curve D and the old
supply curve 8. By reading the new
equilibrium price and quantity off the
respective axes, we see that price has
increased to $4 an hour and quantity has
increased to 80 hours per week. Because
demand has increased, the market price has
increased, and suppliers have moved up their
supply curve and increased the amount that
they are willing to offer for sale (the quantity
supplied). The increased demand curve and the unchanged supply curve have thus caused an increase in
both equilibrium price and equilibrium quantity.

The opposite phenomenon would have occurred if there had been a decrease in demand. If student
incomes had decreased, causing a decrease in demand, the demand curve would have shifted
backward. The new equilibrium point would show that both price and quantity would have decreased.

Now consider the supply side of the tutoring market. Recall that a decrease in babysitting costs causes
an increase in the supply of tutoring. If this increase occurs, the supply curve will shift forward but the
demand curve will not shift. This phenomenon is illustrated by the shift of supply from S to S’ in Figure
1.11.

Figure 1.11 Effects of Increased Supply of Tutoring Services

The Real World

Whew! What a lot of graphs! But you now have learned the basic tools to answer many of life’s
economic questions. All markets have a demand (buyer’s) side and a supply (seller’s) side. And the things
that affect supply and demand are the common sense sorts of things described in the tutoring market
example.

Demand curves shift if the number of buyers changes, if consumers’ tastes change, or if the prices of
other goods that the consumers regard as substitutes or complements change. In our tutoring example,
a substitute for tutoring might be buying and using a study guide that goes along with a textbook.
Substitute relationships occur when the consumer substitutes one good for the other good. A classic
example of substitutes is butter and margarine. Complements are the opposite of substitutes. If the
consumer uses more of one good, he or she will also use more of the other. A good example of
complementary goods is digital cameras and memory cards. If the price of digital cameras goes down, all
other things constant, more digital cameras will be purchased. With more digital cameras in the hands
of consumers, there will be a greater demand for memory cards. Another example of a situation causing
a shift in demand would be an increase in consumer incomes. While we normally expect an increase in
income to cause an increase in demand, this is not always the case. Consider flat screen televisions, for
example. A rise in consumer income will most likely cause a decrease in demand for flat screen
televisions (whose price is now fairly low), but an increase in the demand for three-dimensional TV sets
(still quite expensive).

A final example of a circumstance causing a shift in demand might be an expectation of the future. So if
you read in the newspapers that a large increase in the price of toilet paper is expected next month, you
and others may run out to buy toilet paper today, with the increased current demand actually causing a
rise in its price (a self-fulfilling prophesy that is not uncommon in economics).
Supply curves shift if the number of sellers changes or if the factors that affect the producers’ (sellers’)
costs change. So, a rise in the energy costs of a manufacturer will decrease the supply of manufactured
goods. If businesses must pay higher wage rates to produce the same amount of output; the supply of
output will decrease. On the other hand, if the price of raw materials goes down, the supply of the
product for which the materials are used will increase. If technology improves, such that it becomes
cheaper and easier to produce a product, supply of the product will increase. If the government taxes
the production of a good or service or imposes costly regulations on the supplier, the supply of output
will decrease; if the government provides subsidies (which lowers costs), however, the supply of the
product will increase. Because these examples involve costs of production, we can think of higher costs
of production as squeezing a supplier’s profit margin, and thereby reducing incentives to supply the
product. This would ultimately increase the price of the final product. Lower costs of production would
do the opposite.

Figure 1.12 Summary of the factors that commonly cause the real-world demand and supply curves to
shift.

REFERENCE
Dowling, J.Malcolm, Valenzuela, Ma.R.,Brux, J. (2019) Economic Development Philippine Edition.
Cengage learning Asia Pte Ltd.
Note: You may also read e-books of Economic Development available online

ASSIGNMENT:
Read about Economic development and Economic growth.

COMPILED BY JOHN ROBLES STUDY WELL!

WEEK 2
Efficiency and Equity
In many ways, prices encourage thrift and careful
choices among competing goods. Goods and services
are allocated to those most willing to pay. Thus, the
market is an effective allocative device. Without
prices, products might go to people who do not
strongly desire them and thus be wasted. Shortages
of highly desirable goods and surpluses of less
desirable ones might occur. But in the market, prices
ration away these shortages and surpluses,
suggesting that the marketplace is very efficient as a
means of allocation and distribution.
On the other hand, the distribution of goods and
services may not be equitable. Equity is a value-laden
concept, and economists cannot say whether a
particular distribution is fair. But certain results of
market activity may not seem fair to some of us. A
student may truly need tutoring services but not be
able to afford them and thus fail the course. Children
may go without milk, the homeless without shelter,
and poor pregnant women without prenatal care
because their low incomes render them unable to pay
the prices that the market determines for these
products. We might summarize by saying that the
market entails both positive and negative aspects.
The market place is often efficient, but not necessarily
equitable.
Market Failures and a Glimpse of the Future
Most economists agree that the marketplace performs
many useful functions. In addition to efficiency, a
market-based economy provides economic incentives
and tends to be highly productive. The combination of
competition and proper price signals encourages
efficient production of the products desired by
consumers in the least costly manner. .
Despite the benefits of a market economy, most
economists recognize that the marketplace can also
fail. The existence of many market failures does not
necessarily imply that the marketplace itself ' is a
failure. Rather, it points to ways that the government
may become involved in the marketplace to assure
that all societal needs are met.
Market failures include the following:
1.Public Goods and Services
Public goods and services have unique characteristics
that make it unlikely that the market will provide
enough of them. As a result, the government often
provides them. Public goods and services include
national defense, public libraries, highway
construction, crime prevention, public education, and
others. At least to some point, the use of public goods
and services by some of us does not keep others from
using them. You’re driving on a country road does not
keep others from driving along it. Public goods and
services are unlikely to be provided by the
marketplace because they cannot be divided into
small segments and offered for sale.
Example: It doesn’t make sense for each individual
consumer to purchase one mile of the country road.
Furthermore, if a private consumer does buy such a
good or service, it is difficult to keep people who do
not pay for the product from using it. Am I going to
stand all day to make sure you do not drive on my
own personal mile of the road? The entire notion of a
private market for this country road takes on ridiculous
proportions. It makes far more sense for the local
government to provide the road and ensure its repair.
Most economists agree that the provision of public
goods and services is an appropriate role for
government. Our disagreement concerns just what
goods and services these will be, and how much of
them we want.
2.Spillovers
Neither economic efficiency nor equity occurs when
spillovers exist. Economic spillovers occur when some
cost (or benefit) related to production or consumption
“spills over” onto people not involved in the production
or consumption of the good.
Pollution of our environment is the most obvious
example. If a manufacturer pollutes our air and water
in the process of production, we will bear the costs of
this pollution even if we don’t own the company,
acquire its profits, or buy its products. We bear the
costs of pollution in terms of greater risk of illness,
less aesthetic beauty, and lower-quality environment.
The manufacturer has based its decisions on the
profit motive, and has shifted part of the costs of
production to society at large. Our natural resources
are not being used appropriately, and our economy is
not addressing our real needs and concerns. Our own
dissatisfaction with the degraded environment will not
remedy the problem unless collectively we are able to
channel our concern through active government
involvement.
Other goods and services provide spillover benefits to
society. Education provides significant spillover
benefits to society. The educated person is likely to
provide innovation and creativity in the production
process, and is more likely to vote and otherwise
participate in government and public affairs. The
educated person is less likely to be chronically
unemployed or to commit a violent crime. He or she is
more likely to pay taxes and less likely to be on
welfare. The market will not, by itself, provide
sufficient levels of education, nor does it adequately
compensate students for acquiring (and paying for)
education, because the market place alone does not
reflect these spillover benefits.
3.lnequity
We’ve already noted that the marketplace is not
necessarily equitable. Aside from discrimination,
poverty and inequality of income distribution are also
issues of equity. We may argue that the inability of
low-income people to meet their basic needs is unfair.
Housing, health care, and social security also raise
issues of equity.
4.Market Power
Our example of the demand and supply of tutoring
services at a large university is one that approximates
pure competition. There were many suppliers of
tutoring services so that no single tutor could dictate
the market price. If one of 100 tutors were to charge
an exorbitant price, students would seek the services
of the other 99. Competition protects us from
unreasonable prices. We would not be protected if
there were only one tutor. This monopoly supplier of
tutoring services could charge a high price and
consumers desiring the service would be forced to
pay it. Even if there were a few more tutors available,
this small group could hold back-alley meetings and
fix the price of their services at a very high level.
Without competition, we would be at the mercy of this
group. We would say that the single supplier and/or
the price-fixing group possess market power, which is
the ability of a supplier to influence the market price of
its product. It is only with a large number of tutors-so
many that it is unrealistic for them all to come to
agreement about prices and so many that no
individual supplier produces for a large share of the
market-that market power is absent. To the extent that
many industries consist of just a few dominant
producers (examples are the automobile, steel, and
breakfast cereal industries), competition is reduced
and society’s well-being suffers. Examples of firms
charged with abusing their market power include
Microsoft and Apple. Because market power arises
when a small number of suppliers influence the
market price of their product, it is reasonable to
conclude that a larger number of suppliers, whether
these are domestic or foreign producers, will serve to
reduce market power. Many people are unaware of
the important contribution of international trade in
enhancing competition and reducing market power.
5.Instability
Finally, we return to the topic of production
possibilities and employment. The factors that
determine whether our nation will be on the
production possibilities curve (operating at full
employment) or below the production possibilities
curve (with unemployed resources) are very volatile.
Thus, at times we may have very low employment,
and at other times we may have high employment.
Closely related are the factors affecting the average
level of prices throughout our economy. When the
average price level rises, we say that we have
inflation. Because prices and employment tend to
fluctuate, many say that our market economy is
inherently unstable. In the process, we discover how
our government and our central banking system can
intervene in many ways to ensure greater stability of
prices and employment.
Overview Of Economic Development
The enormous interest in the economic
development of postwar East Asia has continued into
the new millennium. The region’s recent economic
history has been marked by an “economic miracle”
that spanned several decades followed by a severe
financial and economic crisis. Problems of widespread
poverty and economic inequality remain despite
significant economic progress. Addressing these
issues, as well as the impact of developments in the
world economy, is a challenge the region’s
governments, international organizations, and the
economics profession face as a whole. The region
provides fertile ground for economists to study and
address a wide variety of economic development
issues.
East Asia stands out because of the dynamic
economic growth and development it has achieved
throughout the postwar period. The development
process began in Japan when it opened its economy
to increased trade and investment. The rapid
industrialization that followed quickly spread to the
neighboring economies of South Korea, Singapore,
Taiwan, and Hong Kong. Economic growth in these
Newly Industrialized Economies (NIEs), sometimes
called the Asian “tigers,” averaged 8 percent a year in
the three decades prior to the Asian financial crisis in
1997. This growth continued despite two oil crises in
the 1970s, a sluggish world economy in the early
1980s, and rising protectionism and currency
appreciation in the latter half of the eighties.
The industrialization experiences of Japan
and these Asian ‘tigers” formed the basis of the “East
Asian development model,” which has now become
an accepted part of economic development literature.
Recent studies have used this model to characterize
the growth and development in the neighboring
ASEAN economies and China. Inspired by the
success of Japan and the NIEs, Indonesia, Malaysia,
Thailand, and the Philippines developed strategies
that promoted the inflow of foreign capital and
encouraged exports. These outward-oriented
economic policies fuelled rapid growth during the
1980s. China’s economic growth and development
has likewise accelerated since the late 1970s when its
government shifted to an open-door policy that
promoted foreign investment and exports.
However, the remarkable economic record of
the Asian economies was marred by the Asian
financial crisis. Triggered by the collapse of the Thai
baht in July 1997, equity markets and currencies
throughout Southeast Asia came under great
pressure and the ensuing currency devaluations led
to foreign capital flight. Consequently, in a matter of
two months or so, Asia’s once vibrant economies
were plunged into deep recession. This economic
collapse forced an unprecedented reappraisal of
policies ranging from corporate government to
exchange rate management. It also forced a rethink of
the prescriptive policies imposed on the ailing
economies by international development institutions
such as the International Monetary Fund (IMF) and
the World Bank.
After the sharp economic contraction in 1998,
the region rebounded rapidly. In South Korea, for
example, year-on-year industrial production and gross
domestic product (GDP) increased dramatically in
1999 while stock market values doubled in Thailand
and Malaysia. The primary equity market indexes in
Seoul and Singapore returned to their pre-crisis
levels. However, as the US. economy slowed in 2001
and 2002, and war in Iraq and the spread of the
SARS virus took place in 2003, prospects for the
region were adversely affected and the future became
uncertain. And currently, the strike of the COVID-19
pandemic.
The financial crisis also hampered progress in
reducing poverty and addressing other social issues.
The human development gains in health, education,
poverty, and equality, and the distribution of income
achieved by East Asia in the two decades prior to the
crises was eroded to some degree, resulting in slower
growth.
There is no doubt, however, that the
economies of East Asia are in the process of
recovering from the crisis and the region, as a whole,
will play a major role in the global, high-tech world
economy that we are moving towards in this new
millennium.
In South Asia, where the impact of the
financial crisis on the region was not as severe,
economic progress has accelerated following a shift in
policy in the late 1980s and early 1990s.
Nevertheless, this region faces a number of
challenges, including further progress in reducing
poverty and the resolution of political disputes that
have drawn resources away from economic
development.
How is Development Economics Distinct from
other Aspects of Economics?
In today’s classrooms, economic development
concentrates on economies that have low per-capita
incomes. These economies are set apart, for
argument’s sake, from the industrial economies of
Europe, North America, Japan, and Australia/New
Zealand. Economic development considers the
experience of these industrial countries as relevant for
analyzing the process of economic growth. In Asia,
there are many poor countries, as well as some that
have recently joined the group of industrialized
countries, such as Singapore, Hong Kong, Korea, and
Taiwan. We will study all of these Asian economies,
particularly those that have been highly successful in
achieving high growth and high levels of per-capita
income. Many useful lessons can be learned from
them by comparing their development experience with
economies that have grown less rapidly. But we will
not deal with the economies of Central Asia, rather,
we focus on East and Southeast Asia, and South
Asia. Development economists also make use of
analytical tools and methods developed in a variety of
other branches of economics, such as growth theory,
macroeconomics, microeconomics, and labor, to
name just a few. They apply these tools of analysis to
the problems and challenges of developing countries.
Measuring Growth and Development
For many years, economic development was
considered to be synonymous with economic growth
either total economic growth or economic growth in
per-capita terms. The two concepts of economic
growth and economic development are, however, not
necessarily the same. The concept of economic
development is a broader and much more
encompassing view than economic growth, and
relates to levels of social and humanitarian
achievement and income distribution, as well as a
narrower measure of per-capita income.
Using a measure of the amount of goods and services
roduced in an economy in a year, we can get some
idea about the standard of living in that economy.
When the value of these goods increases over time,
there is economic growth. Gross domestic product
(the total value of production in an economy) or gross
national product (GNP-which is GDP plus net factor
income from abroad) is used as a measure of the
nation’s income or production. The size of the total
population can be used to deflate it to per-capita
terms. An improvement in the living standards of the
population is a natural consequence of economic
growth over a period of time. Thus, by looking at GDP
or GNP growth rates, we get some idea about living
standards and how they change over time.
Comparisons of these figures also allow us to relate
the performances of countries or regions in terms of
their growth.
Table 2.1 shows a clearer picture of economic growth
over time as it takes into account population changes
by using data for GDP per capita for 1960 and 2007
Since GDP per capita measures the level of GDP for
each country, it is an indication of the standard of
living at the individual country level. As can be seen,
GDP per capita in the MRS, such as Singapore, Hong
Kong, and Korea, grew rapidly while other countries
such as India and Nepal grew at a slower rate.
Current figures show that Singapore’s GDP per capita
is almost twice that of Korea; more than six times that
of Malaysia, and more than sixteen times that of
China (see last column of Table 2.1).
As noted above, when we speak of economic
development, we usually mean economic growth
accompanied by an improvement in the peoples’
quality of life. To a large degree, economic
development results from economic growth. However,
the experiences of many economies have shown that
economic growth can occur without any improvement
in the quality of the lives of its people. A case in point
is the resource-rich country of Papua New Guinea. Its
mineral-based modern economic sector has grown
quite rapidly in the past few decades, pushing up total
income and income per capita. In spite of this, it is
common to find households in the rural areas
continuing to live at a subsistence level. The fruits of
this economic growth have not been distributed
throughout the society and the government still
provides few opportunities for education and health.
Human development indicators, such as life
expectancy, infant mortality, and the average level of
educational attainment have lagged behind those of
the other countries in the Asian region.
As a result, there is a growing awareness that the
concepts of GDP (and GNP) need to be broadened in
order to include other factors that measure economic
development. As they stand, GDP and GNP are not
sufficiently balanced to adequately capture the
essence of economic development.
New Approaches to Measuring Economic
Development
The Human Development Index (HDI)
The United Nations Development Program (UNDP)
developed the HDI in the late 1980s and has been
publishing it since 1990. This index has three
components: per-capita income and two additional
measures - life expectancy at birth, and level of
educational attainment that combines adult literacy
and educational enrolment rates. These are added to
per-capita income, which is adjusted to reflect the
diminishing marginal use of money, to obtain HDI.
The HDI is developed as a ratio of a particular country
to the most developed country. It varies between zero
and one. Both of these additional indicators are
somewhat related to per-capita income. However, the
HDI can be useful in recognizing that some countries
may have rather low income levels, but still have
achieved a lot in terms of satisfying human needs
(see Table 2.2, ranked in terms of descending HDI
values). Examples are Sri Lanka, China, and several
countries in Central Asia. For other countries, such as
Papua New Guinea and Pakistan, the HDI is much
lower than we would expect by looking at per-capita
income alone.
Several countries, such as Kuwait and Guatemala,
rate much higher in per-capita income terms than they
do with respect to human development. Within Asia,
the rankings are more closely correlated.
Healthy Life Expectancy
A measure used by the World Health Organization
(WHO) summarizes the expected number of years to
be lived in “full health.” The years of ill-health are
weighted according to severity and subtracted from
the overall life expectancy rate to give the equivalent
years of healthy life. According to the latest data
available from the WHO’S Statistical Information
System Online Database, Japanese men have the
longest healthy life expectancy of 72 years among
191 countries, compared with 27 years for the lowest
ranking country, Sierra Leone.
Green GNP
One of the more recent approaches deveIoped to
address the inherent shortcomings of GDP and GNP
as growth and development measures is based on
what is known as the “green” system of national
accounting. Green GNP is the informal name given to
national income measures that are adjusted to take
into account the depletion of natural resources (both
renewable and non-renewable) and environmental
degradation. The types of adjustments made to
standard GNP would include the cost of exploiting a
natural resource and valuing the social cost of
pollution emissions. Damages to the global
environment, such as global warming and depletion of
the ozone layer, should also be deducted; but these
damages are hard to estimate. Others suggest that
“defensive” expenditures, those for environmental
protection and compensation for environmental
damage, including medical expenses, should also be
deducted. The argument here is that these costs
would not have been incurred if the environment had
not been damaged.
Making Comparisons Between Countries
There are two different methods currently in use for
comparing income between countries using the
measure-the exchange rate method and the
purchasing power parity (PPP) method. (Note: in
Table 2.2, PPP measure was used to compare GDP
per capita).
Exchange Rate Method - The exchange rate method
uses the exchange rate between the local currency
and the US. dollar to convert the currency into its US.
dollar equivalent. A country’s GDP and GDP per
capita would then be valued accordingly, in US
dollars.
Purchasing power Parity (PPP) Method - The
purchasing power parity method develops a cost
index for comparable baskets of consumption goods
in the local currency and then compares this with
prices in the United State for the same set of
commodities. A country’s PPP is defined as the
number of units of the country’s currency required to
buy the same amount of goods and services that a
dollar would buy in the United States. Because the
PPP method uses a basket of many goods and
calculates the relative price of these goods, many
economists view this as a better measure of the
relative standards of living than the conventional
exchange rate method described above.
These two different methods can give widely varying
estimates of GDP. In general, the PPP method gives
higher estimates of living standards for developing
countries compared with the exchange rate method.
The reason is that calculations of GDP based on
exchange rate values depend only on the relative
prices of traded goods, whereas the PPP method
considers a basket of goods that include both traded
and non traded goods. Nontraded goods are
generally much cheaper in developing countries and
this helps to lift the estimate of GDP for these
economies. A further advantage of the PPP method is
that it is unaffected by exchange rate changes. As a
result of these advantages, the PPP method has
become the preferred measure of GDP for country
comparisons. One difficulty with the PPP method,
however, is that it is costly to maintain since price
movements need to be updated on a regular basis.
Economic development is a special field of economics
which concentrates on the study of countries which
are in the process of moving upward from low levels
of income, and social progress. There are many
features of an economy that are relevant for calculate and maintain over time, is a better measure
measuring its level of national well-being, including of relative living standards since it is unaffected by
the annual production of goods and services exchange rate fluctuations and includes all goods
(GDP/GNP/GNI) and social indicators, such as life produced rather than traded goods only.
expectancy, educational attainment, and
environmental quality.
To compare and contrast the level of economic
development in different economies, it is useful to
consider all these factors. In particular, it is important
to recognize that there are two popular ways to
compare levels of income: the exchange rate and
purchasing power parity methods. The exchange rate
method has the advantage of simplicity and ease of
calculation. The PPP method, while more costly to
WEEK 3
Introduction:
Week 2’s lessons dealt on economic efficiency
and economic equity. To reiterate, The market place is
often efficient, but not necessarily equitable. That’s
why there are these so-called market failures such as
the problem on public goods and services, the
existence of spillovers, problems on equity, the
presence of market power, and he lack of stability in
our economy. Despite the benefits of a market
economy, most economists recognize that the
marketplace can also fail. The existence of many
market failures does not necessarily imply that the
marketplace itself is a failure. Rather, it points to ways
that the government may become involved in the
marketplace to assure that all societal needs are met.
An important issue is the role of the
government versus the free market. At this present
time of ours, we cannot do otherwise with the
tremendous increases in prices of goods and services.
Face masks for example, has had its tremendous
increase in price due to its increasing demand in the
market. What caused its price increase? You know the
answer definitely! Economic liberals prefer a large role
for government in the economy, and economic
conservatives prefer a small role. As you continue your
reading, you will make your own decisions about
whether you are the liberal or conservative on certain
issues. Finally, you will consider your role within our
world economy.
ECONOMIC DEVELOPMENT
As noted earlier, when we speak of economic
development, we usually mean economic growth
accompanied by an improvement in the peoples’
quality of life. To a large degree, economic
development results from economic
growth. However, the experiences of many
economies have shown that economic growth can
occur without any improvement in the quality of the
lives of its people.
Questions to ponder:
 How do you define economic development?
 What do you view as an economic
development success?
MEGA TRENDS: GLOBAL ECONOMY
An extensive amount of research work has focused on
these mega-trends impacting the global economy.
1. Economic Downturn (Declining public funding)
- The downturn in the U.S. and global economy has
shifted how we measure wealth (e.g., a home may
no longer be a stable investment in some areas),
changed how people view savings (we see an
increase in the personal savings rate in the
country), and slowed job creation
dramatically. The challenges that some
European Union counties are experiencing, the
fledgling movement toward democracy in
countries like Egypt, high oil and gas prices, and
the emergence of China, etc. are all challenging
our traditional approaches to economic
development.
2. Loss of manufacturing jobs and growth in
service industry
- For example, if you examine industry in many
parts of the world, you’ll discover the lifeblood of
their economies has historically been
manufacturing and agriculture. Increasingly, the
growth industry in many countries is now service-
related industries.
3. Polarization of work reflecting knowledge, skills
and abilities
- Employment and jobs are being polarized where
wages tend to reflect the unique knowledge, skills
and abilities of workers. Unskilled production and
assembly jobs are becoming more and more
scarce.
4. Outsourcing that divides ‘value-chain’ functions
into more productive, interdependent activities
- Many of the business activities traditionally done
in-house are now being outsourced. Auto
‘manufacturers’ today are really ‘assemblers’ as
they manufacture very few of the components of
a car. Instead, most are purchased from other
vendors. Even in the non-manufacturing sector
outsourcing can be seen through payroll, human
resources, marketing, graphic design,
programming, etc.
5. Increasing importance of creative/knowledge
economies
- If you’ve read any of the works of Richard Florida
over the past few years, then you know he has
offered a very compelling argument that the future
health of local economies is linked to a
community’s ability to attract creative and
knowledge-based workers, or to generate jobs
that seek these types of talented individuals.
6. Specialization of regions and communities
- Regions and communities are becoming more
specialized and connected to other non-
contiguous places. Places are more frequently
connecting to other places with complementary
specializations. Focus is on the
industry/businesses that can use the region or
community’s skilled workforce, resources and
assets.
7. Expanded growth of entrepreneurs and the self-
employed
- Across the world, a growing number of people are
starting their own businesses, many as self-
employed people. For example, over the past two
decades, the number of self-employed people in
rural America has grown by 2 million and now
represents over 20 percent of its
workforce. Estimates suggest this rate will
continue to accelerate over the next decade or
more.
8. Connections among places with
complementary specializations or resources
MEGA TRENDS: ECONOMIC DEVELOPMENT
Now, let’s look at some of the mega-trends that deal
specifically with economic development. You may
note that not all of these trends are necessarily ‘good
things’ happening in the economic development
arena. Instead, some actually discuss some of the
traditional ways we have approached economic
development – approaches that may not work very well
in today’s global environment.
Where do you see disconnects between these mega-
trends in economic development and the global
economy mega-trends? Where do you think they
complement one another?
1.Continued focus on companies rather than
industries and people
- Every morning when economic development
leaders wake up and get on with their work, many
are still focusing on attracting a major company to
their community. It doesn’t matter to them what
type of company they capture, they just want to
get the number of jobs they have attracted to go
up. Might it be a better strategy to recruit specific
firms that can further strengthen and add value to
one of the region’s key industrial sectors,
especially if it’s a sector that is likely to enjoy
stability or growth over the long-term?
2. Need for talented workforce to be competitive
- Manufacturing in the rural U.S. represents a great
example of this point. Years ago, manufacturing
plants that were located in rural areas were
looking for cheap, low-skilled labor. In order to
survive in today’s global environment,
manufacturing plants have had to raise the skill
requirements of their workers and have had to
introduce technological innovations.
3. Greater scrutiny of public economic
development investments
- The debate about the benefits and costs of
offering incentives to companies to locate to a
state or community remains pretty heated. Do
publicly paid incentives for such purposes
work? The research seems to be mixed, and
with the increasing scrutiny by citizens on how
taxpayer monies are used, this is a debate that is
likely to rage on for some time
4. Emphasis on Job Creation
5. Need for economic developers with new skills
in marketing and networking
THREE WAVES OF ECONOMIC DEVELOPMENT
“The evolution of economic development is often
discussed in terms of the ‘three waves.’
The FIRST WAVE was dominated by programs
specifically designed to attract footloose firms from old
industrial areas to growing regions, such as the South
or West. The typical tools included subsidized loans or
direct payments to firms for relocation expenses, tax
reductions, subsidies applied to the cost of plant
facilities or utilities, and competitive and expensive
industrial recruitment programs. The building of
industrial parks was also part of the first wave strategy.
By the early 1980s, states began operating
many SECOND WAVE incentives, ones that shifted
focus from attracting out-of-state firms to retaining and
expanding existing firms. With the introduction of
deregulation in the early 1980s, firms had to find ways
to reduce costs in order to compete. In some cases,
manufacturing firms embraced lean manufacturing
strategies in hopes of reducing inefficiencies in their
production activities. Other companies consolidated in
order to reduce costs. It was during this period that job
training and technical assistance activities targeted to
businesses were on the rise, including support for
business start-ups. The bottom line was to strengthen
the health of existing industries.
The second wave has now given way to the THIRD
WAVE which shifts the focus to regional
competitiveness, focusing on efforts to promote
innovation and entrepreneurial activities. In some
cases, attention is given to the strategic linking of
similar types of businesses in order to create
clusters. In other situations, the focus is on unique
regional assets or amenities (such as the growth of the
artisans region in North Carolina under the banner of
Handmade in America). A third aspect of this wave is
focused on seeding the growth of entrepreneurs as a
way of introducing new products or services, especially
products and services that relate to and help
strengthen the regional aspects of the economy.
Many regions are now pursuing some combination of
these regional strategies. In some cases, this includes
the building of the right regional governance structure
to help get these types of efforts off the
ground. Leadership development activities have been
a fruitful way to help create and strengthen the
emergence of effective regional governance
structures.”
Another way to consider the changes in economic
development is to look at the shift that is occurring, that
is, from OLD to NEW. In the past, the primary approach
was a focus on attraction (e.g., the effort to incent a
company to move from an existing location to another
location) with little focus on supporting and retaining
existing businesses.
OLD ECONOMIC DEVELOPMENT
Too often the message was that our location is
a ‘cheap’ place to do business (e.g., we have cheap
land, cheap labor [people who work for low wages], and
low or non-existent taxes). A great physical
environment (parks, bike paths, vibrant downtown,
social activities, etc.) was considered a luxury, as we
had to use available financial resources to attract the
companies, not create a great community.
Most communities and regions worked hard to
develop a competitive advantage in a resource (wood,
a particular industry, lots of water, workers with specific
skill). They tended to ‘win’ because of this
advantage. One example is regions that had a
concentration in the auto industry. Because of that
concentration, they tended to attract more linked
businesses.
Economic development was also always led by a state
or local government agency with little input or
involvement from the business community or the
nonprofit sector.

NEW ECONOMIC DEVELOPMENT

Economic development now focuses much more on
creativity, entrepreneurial spirit and range of worker
talent. Available land, low taxes and incentives are still
factors, but not the primary factors as in the
past. There is a strong focus on the region, rather than
a single community. To be successful, these regions
must have the ability to learn and adapt to the changing
global economy.
Most importantly, economic development today is
successful only when a partnership between the
business, government and nonprofit sectors exists. By
working together, they can create a community/region
that is attractive to new residents (workers) and
businesses, while continuing to provide for the existing
businesses and residents.

ECONOMIC GROWTH
This is the rise in the money value of goods and
services produced by all the sectors of the economy
per head during a particular period. Moreover, it can
be expressed in terms of GDP and GNP that helps in
measuring the size of the economy.
Economic Growth Determinants include the following:
 Human resources
 Natural resources
 Capital formation
 Technological development
 Political and Social factors
WEEK 4
Lesson Proper:
Why do economies grow? Why should
they grow? Why do we want them to grow
faster?
These are the sorts of questions that
economic development and macroeconomic
subjects are concerned with. Of course, there are
many other subjects that economists are interested
in, but we will be primarily looking at economic
growth and economic development. Some
economists like to distinguish between growth and
development.
IMPORTANT CONCEPTS FOR
UNDERSTANDING GROWTH
We will study a number of theories that may
explain the growth experiences of countries over
time. To facilitate understanding of these theories,
we first discuss some fundamental economic
concepts.
Components of Income and Output
Output is derived by combining various
factors of production, which include land, capital
and labor. Normally, we take the supply of land as
fixed and assume that its productivity can be
enhanced by the application of labor or capital, the
two variable inputs which are combined in a
standard production function.
The production function is a useful tool for
analyzing the process of economic growth. A
production function relates the inputs of the
production process, such as labor (L) and capital
(K), to the output/income (Y) from the process. This
relationship can be stated in a number of ways. A
general function (f) without any functional form can
be stated as:
Y= f(K, L)
As labor and capital grow over time, so will
income. What are some of the attributes of this
relationship?
To a large extent, the law of diminishing
returns governs the growth process. As each
worker acquires more capital, it follows that there
would be diminishing returns to that capital. If this
process were to continue for a long enough period,
growth would slow to zero. However, this has not
been the experience of the industrialized nations.
Why? This is principally because of changes in the
nature of the capital and labor and the way they are
organized to produce output. The former is
sometimes called embodied technical progress,
and the latter disembodied technical progress.
Embodied technical progress is reflected by
the fact that labor forces have tended to become
more educated over time as more resources are
spent on upgrading the skills of the existing labor
force and also on educating the young.
Technological developments also tend to increase
the productivity of capital. These developments are
the result of innovation and invention. In the last
decade, advances in information and computer
technology have been the most apparent sources
of innovation. These have both changed the nature
of capital and labor inputs and the way that they are
combined to create output.
In terms of the kind of disembodied
technical progress seen in applications in
information and computer technology, there have
been advances in management and industrial
organization that have increased the level of output
even when the amounts of labor and capital are
fixed. The Internet as a tool for communication,
information collection, and dissemination has
increased in importance, and the use of computers
to monitor and control production has become
widespread. As a result, production processes have
been streamlined, the need to keep large inventory
of raw and semi-finished goods has been reduced,
and the flexibility of production processes has
increased.
To summarize, at any level of capital and
labor inputs, there will be an associated level of
output. When the output increases at the same rate
as the inputs, we refer to the production function as
having constant returns to scale. This means that in
Equation Y=f(K, L) we could multiply each input by
some constant and the output would increase by
that constant amount.
In what follows, we will explore various
aspects of the production function and technology
that can change the relationship. For example,
researchers have studied the rate of increase in
labor, capital, and output. The evidence from these
studies suggests that output increases more rapidly
than inputs. If technology were fixed, this would
imply that there would be increasing returns to
scale, that is, that output would increase faster than
inputs. However, as technology has changed, we
have to interpret the difference between input and
output growth in a slightly different way.
The size of the labor force will increase over
time as a lagged consequence of the natural
increase in population. The capital stock will also
increase as a result of investment. While it depends
on how these factors are combined and the shape
of the production function, increases in labor and
capital will result in an increase in output and
income. Historically, there has been a significant
rate of growth per-capita income over time and this
has resulted in higher standards of living more
goods and services per capita-for many regions of
the world. The Contribution of the two kinds of
technological advance has also played a critical
role in raising the standards of living. The next
section will discuss how these two distinct
contributing factors of embodied and disembodied
technical progress can be measured.
Total Factor Productivity
By investigating the rate of growth of labor
and capital together with income and output,
economists have observed that there is some
growth in output that is unaccounted for by the
growth of labor and capital in the standard
production functions, even when adjustments are
made in the quality of the labor and capital inputs.
In some cases, this discrepancy or residual is quite
large. This residual has been called total factor
productivity (TFP), or multifactor productivity.
TFP pertains to the efficiency with which the
inputs are combined to produce output. These
efficiency gains can be due to a number of factors,
including greater economies of scale, better
management, marketing or organizational abilities,
shifts in production from low productivity activities
to higher productivity activities with the same
amount of labor and capital, or the impact of new
technology which enables greater output to be
obtained with the same capital and labor inputs.
If we call this TFP, or multifactor
productivity, term A, and denote capital and labor
by K and L respectively, then the production
function can be rewritten as Y=f(K, L, A). This
equation is a general expression. Often,
economists assume that competitive conditions
exist in capital and labor markets and there are
constant returns to scale. If this is the case, then
we can show that the growth rate of income is
equal to the growth rates of the capital and labor
inputs weighted by their shares in national income:
g(Y) =g(K) W(K) +g(L) W(L) + A
where g(Y) is the growth rate of income, g(K) is the
growth rate of capital (investment), g(L) is the
growth rate of labor, and W(K) and W(L) are the
weighted shares of capital and labor in the
economy. The growth rate of income thus equals
the sum of the three terms. The first term is the
growth rate of capital multiplied by the ratio of
capital to labor, and by a term that is the marginal
product of capital. The second term is similar to the
first term except that it is for labor. The third term
involves the efficiency factor, A.
If we assume that labor and capital are paid
the value of their marginal products, the result
would be that the growth in output would be equal
to the sum of three factors: the growth rate of
capital multiplied by its share of output plus the
growth rate of labor multiplied by labor’s share in
output plus a residual term. Notice that this residual
term measures both embodied and disembodied
technical progress. To the extent that we can adjust
the labor and capital inputs to reflect changes in the
level of skill of the labor force and the quality of
capital inputs, we can incorporate embodied
technical progress into the first two terms.
However, to the extent that we miss out on some of
this embodied technical progress, it will be included
in the efficiency term A.
Working through an example, suppose a
country has a growth rate of income of 6 percent, a
growth rate of capital (net of depreciation) of 10
percent, and capital’s share of income is 30-
percent, labor’s Share is 70 percent and labor
grows at 1 percent, then the sum of the terms on
the right-hand side, apart from A, will be
0.06 = A + 0.3(0.10) + 0.7(0.01)
In this example, A = 0.023 and technical
progress accounts for just a little less than 40
percent of the output growth of 6 percent. There
are, of course, many assumptions in this model.
The biggest assumption is that factors are paid the
value of their marginal product and that the two
factors, K and L, exhaust total output, in the sense
that their coefficients add up to one. This is
essentially a constant return to scale argument so
that we do not allow for output growth to exceed the
rate of growth of labor and capital.
Notice also that the growth in income will be
raised if the investment rate is increased or if the
labor force increases more rapidly. Efficiency,
meanwhile, is assumed to be unchanged.
Economic Efficiency
The production possibility frontier (PPF) is a
curve depicting the best possible combination of
goods that is produced in an economy-best in the
sense that the combination utilizes all the available
inputs efficiently and minimizes waste. The case for
an economy that produces only two goods-cell
phones and jeans-is shown in Figure 3.1. In Figure
3.1a, the point A on the y axis is the production
option where all inputs are used to manufacture cell
phones only, while the point D on the x axis is the
production option that uses all available inputs for
the productions of jeans alone. The points B and C
are production options where all available inputs
are used for the production of some cell phones
and jeans. Each point-A, B, C, and D (as well as
other combinations on the curve)--trace the PPF
curve of the economy. Each point on this curve
represents the maximum number of jeans and/or
cell phones that can be produced according to the
inputs to the production process. In this sense,
these combinations are efficient and the PPF,
therefore, represents the “best practice” firms in the
economy. In contrast, a production combination
represented by a point inside the PPF curve, say B,
does not utilize all the available resources for
economic production; With some resources
remaining idle, this production option is considered
inefficient.
Economic efficiency is boosted in a static
sense (static efficiency) if firms move from inside
the production possibility frontier, say point B,
toward the frontier itself, to point E’. An
improvement in economic efficiency of this type
could lead to a one-time increase in income but it
would not arrest the tendency toward decreasing
returns. This drift toward decreasing returns is one
reason that richer economies tend to grow more
slowly than some poorer economies. There are, of
course, many other factors involved in growth,
which is why many poor countries, particularly in
Africa and Latin America, have also experienced
slow or even negative growth in per-capita income
Improvements in economic efficiency can
take place in a number of ways, including the move
toward best practice through better management
and organization. This could be done by
implementing better inventory-control measures,
better relations between management and labor,
new methods of organizing the way products are
assembled (within the existing capital structure and
labor-force configurations), and so on.
By contrast with static efficiency, dynamic
efficiency takes place when there is economic
growth and the scale of production increases (scale
efficiencies), or production shifts from a low
productivity sector to a more productive sector. In
Figure 3.1b, this is represented by an outward shift
of the PPF curve (the dotted line).
In Asia, much of the dynamic efficiency
resulted from a shift from the less efficient
agricultural sector to a more efficient industry. Such
inter-industry shifts usually take place quickly when
an economy is growing rapidly. Dynamic efficiency
can also result from new innovations and inventions
which boost total factor productivity. It can also be
due to more effective marketing and distribution
arrangements, sometimes with foreign outlets.
Large-scale operations also allow bulk purchasing
and quantity discounts that are unavailable to
smaller-scale operations. Many multinational firms
also use different production sites to manufacture
different components of a product in order to take
advantage of lower costs. These components are
then shipped to other locations where they are
assembled and delivered to buyers. Since dynamic
efficiency leads to an outward shift of the
production possibility frontier, it leads to a higher
level of output for the same level of capital and
labor inputs. Dynamic efficiency may also involve
the use of new technology and innovations as old
capital equipment is replaced and older workers are
either replaced or retrained.
Technical Progress
As noted above, there are two kinds of
technical progress or innovation that can be
achieved by an economy. Embodied technical
progress has to do with the changing nature of the
inputs into the production process. These would
include more highly skilled and computer-literate
workers, or less stressed and more congenial
workers, or the installation of new innovations in
capital equipment. Disembodied technical
progress, on the other hand, relates to the way
factors are combined together in the workplace,
such as management or organizational innovations.
This type of technical progress would be contained
in the residual, A, in Equation Y= f(K, L, A) and
would arise from the way in which factors are
combined together within the firm and the industry.
Practically, it is unlikely that all the
embodied technical progress will be captured in the
measures of labor and capital. Usually, it is hard to
get good estimates of the capital stock as we tend
to rely on investment figures to measure the
increment to capital. These f1gures are measured
in a monetary unit and therefore do not tell much
about the amount of new innovation or technology
contained in this new capital. Similarly, labor input
is usually measured in terms of man-hours or man-
years worked.
However, new, more highly trained and
educated workers enter the workforce all the time
and older workers retire. These figures are not
ordinarily used to construct a new labor series each
year that reflects this higher embodiment of
education and skill into the hours or years worked.
There are, nevertheless, attempts to use a range of
educational attainment variables to measure these
labor-force effects separately. There have also
been attempts to measure what are called vintage
production function that is, production functions
which assume that each year has a new vintage of
capital that has higher innate productivity than do
capital investments in previous years. By
constructing a vintage capital model, some
economists have been able to reduce quite
substantially the size of the residual, A, in the
neoclassical production in Equation Y= f(K, L, A).
However, similar attempts to construct vintage
labor production functions have not been widely
made, primarily because people, unlike capital, can
increase their productivity during their lifetime.
Therefore, it is unrealistic to assume that each new
cohort of graduates is more qualified than older
workers. Thus, in practice, the residual term will
probably contain elements of both disembodied and
embodied technical progress.
In growth accounting, the shares of the
different factors of production are assumed to be
known and are not estimated as they would be in,
say, a Cobb-Douglas constant elasticity of
substitution, or variable elasticity of substitution
model. These growth accounting models assume
that the shares of labor and capital in the national
accounts are marginal products of these factors
and are simply added to the factors contributing to
output. The contribution of other factors, such as
education and technological innovation, can also be
incorporated by constructing a new series or by
adjusting the existing series. For example, the labor
input can be adjusted by multiplying the labor
series by an index of rising educational attainment
over time, or by introducing a new factor of
production, such as education, and measuring its
separate contribution to output.
Growth accounting is useful because it is a
shorthand method for assessing technical progress.
It does not require calculating a production function,
which can often be complicated by the lack of
reliable information on capital stock and labor
supply, and difficulties in empirical
estimation.
*** END of LESSON ***
WEEK 5

GROWTH THEORIES

KEYNESIAN THEORY This model stresses the A simplified model of Harrod-Domar:

accumulation of capital. They include Rostow’s
(1960) stages of growth model and the Harrod-
Domar growth model (see Harrod, 1939; and Domar,
1946) which will be discussed below. Growth among
countries using these models could easily diverge.
The models do not explicitly consider the law of
diminishing returns to capital which can take effect
as growth proceeds. In this sense, they are not
particularly realistic.

The Keynesian Growth Theory and the

HarrodDomar Model
• It is a classical Keynesian model of economic
growth that is used in development economics
to explain an economy’s growth rate in terms of
the level of saving and productivity of capital.
• The Harrod-Domar (1939, 1946) model is the
simplest macroeconomic model. It begins with
the assumption that saving is a constant
proportion of income. We first define income Y
as the sum of consumption C and saving S, and
that saving equals investment.
The Harrod-Domar model of growth seeks to explain
two (2) basic questions relating to growth problems
of developed countries. They are:
• What are the requirements to maintain steady
rate of growth of full employment income
without inflation and deflation?
• Is long run full employment equilibrium of a
developed economy possible without secular
stagnation or secular inflation?
This model provides gainful suggestions to above
questions:
Regarding steady rate of growth of full employment
income, Harrod_Domar model conveys that rate of
investment should increase at a rate equal to the
proportion between marginal propensity to save and
capital output ratio.
As regards second question, Harrod-Domar are of
the view that it is difficult to maintain steady rate of
growth of full employment in a capitalist economy.
There are possibilities of secular inflation or secular
deflation in the capitalist economy.
The Harrod Domar Model suggests that the rate of
economic growth depends on two things:
• Level of Savings (higher savings enable higher
investment)
• Capital-Output Ratio. A lower capital-output
ratio means investment is more efficient and
the growth rate will be higher.
Level of savings. Higher savings enable greater
investment in capital stock
The marginal efficiency of capital. This refers to
the productivity of investment, e.g. if machines
costing $30 million increase output by $10 million. The
capitaloutput ratio is 3
Depreciation – old capital wearing out.
Three kinds of Growth according to
HarrodDomar:
1. Warranted Growth Rate – also known as
“fullcapacity” growth rate
Roy Harrod introduced a concept known as the
warranted growth rate.
• This is the growth rate at which all saving is absorbed
into investment. (e.g. $80 of saving = $80 of
investment.
• Let us assume, the saving rate is 10% and the capital-
output ratio is 4. In other words, $10 of investment
increases output by $2.5. • In this case, the
economy’s warranted growth rate is
2.5 percent (ten divided by four).
• This is the growth rate at which the ratio of capital
to output would stay constant at four.
2.The Natural Growth Rate
• The natural growth rate is the rate of economic
growth required to maintain full employment.
• If the labour force grows at 3 percent per year, then
to maintain full employment, the economy’s annual
growth rate must be 3 percent.
• This assumes no change in labour productivity which
is unrealistic.
3.Actual Growth
• It is determined by the actual rate of savings and
investment in the country. In other words, it can be
defined as the ratio of change in income to the total
income in the given period. Importance of Harrod-
Domar
• It is argued that in developing countries low rates of
economic growth and development are linked to low
saving rates.
• This creates a vicious cycle of low investment, low
output and low savings. To boost economic growth
rates, it is necessary to increase savings either
domestically or from abroad. Higher savings create a
virtuous circle of self-sustaining economic growth.
Impact of increasing capital
The transfer of capital to developing economies
should enable higher growth, which in turn will lead
to higher savings and growth will become more
selfsustaining.
The Main points of the Harrod-Domar Analysis:
• Investment is the central variable of stable growth
and it plays a double role; on the one hand, it
generates income and on the other hand, it creates
productive capacity.
• The increased capacity arising from investment can
result in greater output or greater unemployment
depending on the behavior of income.
• Conditions concerning the behavior of income can
be expressed in terms of growth rates and equality
between the three growth rates can ensure full
employment of labor and full utilization of capital
stock.
• These conditions, however, specify only a
steadystate growth. The actual growth rate may
differ from the warranted growth rate. If the actual
growth rate is greater than the warranted rate of
growth, the economy will experience cumulative
inflation. If the actual growth rate is less than the
warranted growth rate, the economy will slide
towards cumulative inflation. If the actual growth
rate is less than the warranted growth rate, the
economy will slide towards cumulative deflation.
• Business cycles are viewed as deviations from the
path of steady growth. These deviations cannot go
on working indefinitely. These are constrained by
upper and lower limits, the full employment ceiling
acts as an upper limit and effective demand
composed of autonomous investment and
consumption acts as the lower limit. The actual
growth rate fluctuates between these two limits.
Criticisms of Harrod-Domar Model
o Developing countries find it difficult to increase
saving. Increasing savings ratios may be
inappropriate when you are struggling to get
enough food to eat.
o Harrod based his model on looking at industrialised
countries post-depression years. He later came to
repudiate his model because he felt it did not
provide a model for long-term growth rates.
o The model ignores factors such as labour
productivity, technological innovation and levels of
corruption. The Harrod-Domar is at best an
oversimplification of complex factors which go into
economic growth.
o There are examples of countries who have
experienced rapid growth rates despite a lack of
savings, such as Thailand.
o It assumes the existences of a reliable finance and
transport system. Often the problem for developing
countries is a lack of investment in these areas.
o Increasing capital stock can lead to diminishing
returns. Domar was writing during the aftermath of
the Great Depression where he could assume there
would always be surplus labour willing to use the
machines, but, in practice, this is not the case.
o The Model explains boom and bust cycles through
the importance of capital, (see accelerator theory)
However, in practice businesses are influenced by
many things other than capital such as expectations.
o Harrod assumed there was no reason for the
actual growth to equal natural growth and that an
economy had no tendency to full employment.
However, this was based on the assumption of
wages being fixed. o The difficulty of influencing
saving levels. In developing economies it can be
difficult to increase savings ratios – because of
widespread poverty.
o The effectiveness of foreign capital flows can vary.
In the 1970s and 80s many developing economies
borrowed from abroad, this led to an inflow of
foreign capital however, there was a lack of skilled
labour to make effective use of capital. This led to
very high capital-output ratios (poor productivity)
and growth rates didn’t increase significantly.
However, developing economies were left with high
debt repayments and when interest rates rose, a
large proportion of national savings was diverted to
paying debt repayments.
o Economic development implies much more than
just economic growth. For example, who benefits
from growth? does higher national income filter
through to improved health care and education. It
depends on how the capital is used.
Definition of the Accelerator Effect
The accelerator effect states that investment levels
are related the rate of change of GDP. Thus an
increase in the rate of economic growth will cause a
correspondingly larger increase in the level of
investment. But, a fall in the rate of economic growth
will cause a fall in investment levels.
SOLOW OR NEOCLASSICAL THEORY These
models stress the neoclassical economic principle that
factors of production should be paid the value of their
marginal products. In these models, the law of
diminishing returns can operate and there is mobility
of factors to seek their highest return. These models
have all been developed on the basis of the
SolowSwan (1956) model. They were favored by most
mainstream economists for more than thirty
yearsfrom the early 1960s or late 1950s when the
Solow model was first published until quite recently.
These models show a convergence in growth among
countries and also imply that there will be a slowdown
in growth in the absence of technical progress as a
result of diminishing returns.
What is the Solow Growth Model?
The Solow Growth Model is an exogenous model of
economic growth that analyzes changes in the level
of output in an economy over time as a result of
changes in the population growth rate, the savings
rate, and the rate of technological progress.
The Solow Growth Model, developed by Nobel
Prizewinning economist Robert Solow, was the first
neoclassical growth model and was built upon the
Keynesian Harrod-Domar model. The Solow model is
the basis for the modern theory of economic growth.
Simplified Representation of the Solow
Growth Model Assumptions:
a. The population grows at a constant rate g.
Therefore, current population (represented by N)
and future population (represented by N’) are
linked through the population growth equation N’
= N(1+g). If the current population is 100 and the
growth rate of population is 2%, the future
population is 102.
b. All consumers in the economy save a constant
proportion, ‘s’, of their incomes and consume the
rest. Therefore, consumption (represented by C)
and output (represented by Y) are linked through
the consumption equation C= (1+s)Y. If a consumer
earns 100 units of output as income and the savings
rate is 40%, then the consumer consumes 60 units
and saves 40 units.
c. All firms in the economy produce output using the
same production technology that takes in capital
and labor as inputs. Therefore, the level of output
(represented by Y), the level of capital (represented
by K), and the level of labor (represented by L) are
all linked through the production function equation
Y = aF(K,L).
The Solow Growth Model assumes that the
production function exhibits constant-returns-to-
scale (CRS). Under such an assumption, if we double
the level of capital stock and double the level of
labor, we exactly double the level of output. As a
result, much of the mathematical analysis of the
Solow model focuses on output per worker and
capital per worker instead of aggregate output and
aggregate capital stock.
1 Present capital stock (represented by K), future
capital stock (represented by K’), the rate of capital
depreciation (represented by d), and level of capital
investment (represented by I) are linked through the
capital accumulation equation K’= K(1-d) + I.
Implications of the Solow Growth Model
There is no growth in the long term. If countries have
the same g (population growth rate), s (savings rate),
and d (capital depreciation rate), then they have the
same steady state, so they will converge, i.e., the
Solow Growth Model predicts conditional
convergence. Along this convergence path, a poorer
country grows faster.
Countries with different saving rates have different
steady states, and they will not converge, i.e. the
Solow Growth Model does not predict absolute
convergence. When saving rates are different, growth
is not always higher in a country with lower initial
capital stock.
POWER-BALANCE THEORY These models stress
international power balance as an important factor in
development, including the terms and patterns of
trade which tend to keep some countries poor while
other countries get richer. In one sense, the
international power-balance model can be considered
as a subclass of the neoclassical model where there is
a lack of factor mobility in international trade.
In addition, these theories, which were popular when
North-South issues were being stressed, were based
on the assumption that the poor “southern”
economies were being exploited by the rich industrial
“northern” countries. In these models, the poor
countries export raw materials to the industrial
countries in exchange for industrial goods. Because
the terms of trade (that is, the price of raw materials
vis-a-vis manufactured goods) tend to deteriorate
over time, the power balance theories assert that the
poor countries have to export more and more raw
materials in order to keep from slipping backward. As
a result, their development is retarded. The
development of industrial capacity in East and
Southeast Asia, and in some Latin American countries,
has caused these theories. to become discredited
generally, although there are elements of truth in this
paradigm in Africa, where raw materials are still the
main exports. These theories also assume that when
incomes are low, these countries will not be able to
save much. Thus, the assumption is that the saving
rate is not independent of income, as in the Harrod-
Domar model. In addition, because of poverty, it is
difficult to achieve high productivity in agriculture or
even to improve productivity in agriculture.
Balance of power, in international relations, the
posture and policy of a nation or group of nations
protecting itself against another nation or group of
nations by matching its power against the power of
the other side. States can pursue a policy of balance of
power in two ways: by increasing their own power, as
when engaging in an armaments race or in the
competitive acquisition of territory; or by adding to
their own power that of other states, as when
embarking upon a policy of alliances.
The term balance of power came into use to denote
the power relationships in the European state system
from the end of the Napoleonic Wars to World War I.
Within the European balance of power, Great Britain
played the role of the “balancer,” or “holder of the
balance.” It was not permanently identified with the
policies of any European nation, and it would throw its
weight at one time on one side, at another time on
another side, guided largely by one consideration—
the maintenance of the balance itself. Naval
supremacy and its virtual immunity from foreign
invasion enabled Great Britain to perform this
function, which made the European balance of power
both flexible and stable.
STRUCTURALTHEORY These models emphasize
the shifts in resources between different sectors on
the supply side. These theories discuss the transition
from labor-intensive agriculture, which relies on
traditional, low-productivity farming techniques, to
modern, high productivity industries which have
benefited from innovation and more intensive use of
capital and technology.
The structuralist approach models economic growth
as a process of shifts in resources among sectors. It
stresses rigidities that hinder this shift in resources
and it studies how the shift in output among
different sectors takes place over time as
development progresses. In particular, a systematic
shift in output has been observed in the process of
development in the industrial countries, as well as in
many developing countries. This process involves a
decline in agriculture’s contribution to GDP, an
increase in industrial output up to a point when it too
begins to decline, and finally an increase in the
component of services income as a share of GDP,
which has not yet begun to decline. As a result, very
rich countries, such as the United States, have a very
large proportion of GDP in the services sector-as
much as 60 to 70 percent. Agriculture contributes a
very small part in terms of value added to GDP,
perhaps 6 percent, while industry makes up the
difference. In rapidlygrowing industrializing
countries, the share of industry would be larger and
still growing, while agriculture would be large but
falling. Although services would be rising, it would
have a smaller share in GDP. A very poor country
would have most of its resources in agriculture and
very little in services or manufacturing.
The source of rapid growth, from the structuralist
point of view is manufacturing. Productivity increases
faster in manufacturing and remains high for many
years as technological developments are made or
copied from other countries. The reason that
industrial countries grow slowly, from this
perspective, is that productivity in the services sector
has historically been low and has not grown as fast as
productivity in manufacturing.
Although this may be changing as a result of the
technological revolution, leading to higher rates of
growth, this “new productivity revolution” has not
yet been firmly established. Lower growth in the
services sector is still a drag on the economic
performance of the industrial countries. Another
contributing factor to slower growth in the industrial
countries is that their rates of saving and investment
are lower than in rapidly growing poorer countries.
Therefore, the industrial countries have to depend to
a greater extent on TFP and new innovations, as well
as human capital development through education for
their growth.
The Lewis-Fei-Ranis Model This model is under
the structuralist theory. A very well-known theory of
development is the so-called Lewis Fei-Ranis (LFR)
model (Lewis, 1954; and Fei and Ranis, 1961). There
are elements of this model which are very important
to understanding the pattern of development in
many countries. It tries to explain how the process of
industrialization takes place and how inefficiencies
can arise. There are two sectors in the LFR model: a
modern sector and a traditional sector. The former is
primarily based in cities and the latter in the
countryside. The rural sector has low capital
accumulation and low labor skill. Its productivity and
earnings capabilities are also very low. The modern
sector has high productivity and pays higher wages.
Labor thus moves from the countryside to the city to
take advantage of wage differentials.
The Fei–Ranis model of economic growth is a
dualism model in developmental economics or
welfare economics that has been developed by John
C. H. Fei and Gustav Ranis and can be understood as
an extension of the Lewis model. It is also known as
the Surplus Labor model. It recognizes the presence of
a dual economy comprising both the modern and the
primitive sector and takes the economic situation of
unemployment and underemployment of resources
into account, unlike many other growth models that
consider underdeveloped countries to be
homogenous in nature. According to this theory, the
primitive sector consists of the existing agricultural
sector in the economy, and the modern sector is the
rapidly emerging but small industrial sector. Both the
sectors co-exist in the economy, wherein lies the crux
of the development problem. Development can be
brought about only by a complete shift in the focal
point of progress from the agricultural to the
industrial economy, such that there is augmentation
of industrial output. This is done by transfer of labor
from the agricultural sector to the industrial one,
showing that underdeveloped countries do not suffer
from constraints of labor supply. At the same time,
growth in the agricultural sector must not be
negligible and its output should be sufficient to
support the whole economy with food and raw
materials. Like in the Harrod–Domar model, saving
and investment become the driving forces when it
comes to economic development of underdeveloped
countries.
Fei–Ranis model of economic growth has been
criticized on multiple grounds, although if the model is
accepted, then it will have a significant theoretical and
policy implications on the underdeveloped countries'
efforts towards development and on the persisting
controversial statements regarding the balanced vs.
unbalanced growth debate.
• It has been asserted that Fei and Ranis did not have
a clear understanding of the sluggish economic
situation prevailing in the developing countries. If
they had thoroughly scrutinized the existing nature
and causes of it, they would have found that the
existing agricultural backwardness was due to the
institutional structure, primarily the system of
feudalismthat prevailed.
• Fei and Ranis say, "It has been argued that money is
not a simple substitute for physical capitalin an
aggregate production function. There are reasons to
believe that the relationship between money and
physical capital could be complementary to one
another at some stage of economic development, to
the extent that credit policies could play an
important part in easing bottlenecks on the growth
of agriculture and industry." This indicates that in
the process of development they neglect the role of
money and prices. They fail to differ between wage
labor and household labor, which is a significant
distinction for evaluating prices of dualistic
development in an underdeveloped economy.
• Fei and Ranis assume that MPPLis zero during the
early phases of economic development, which has
been criticized by Harry T.Oshima and some others
on the grounds that MPPL of labor is zero only if the
agricultural population is very large, and if it is very
large, some of that labor will shift to cities in search
of jobs. In the short run, this section of labor that has
shifted to the cities remains unemployed, but over
the long run it is either absorbed by the informal
sector, or it returns to the villages and attempts to
bring more marginal land into cultivation. They have
also neglected seasonal unemployment, which
occurs due to seasonal change in labor demand and
is not permanent.
NEW GROWTH THEORY The most recent growth
theories, simply called “new growth theories” try to
endogenize technical progress and make use of
assumptions of increasing returns to scale and
positive externalities. These assumptions contrast
sharply with the neoclassical model which stresses
diminishing returns and a slowdown of growth to a
steady-state rate.
The new growth theory has been developed in the
last decade by a number of younger economists who
became dissatisfied with the Solow-Swan (1956)
model. The new growth theory attempts to
endogenize technical change by using external
economies and spillovers. These operate on the basis
of beneficial effects which new technology and
higher levels of education have on other sectors of
the economy. These externalities help to generate
increasing returns to scale and drive the growth
process to higher levels of income, instead of slowing
growth through diminishing returns. One of the
important features of this model is the mechanism by
which technology is transferred from one firm to
another within an industry in a single country and
then across international borders. One group of
economists working on this model contends that the
development of new technology in industrial
countries is passed on to other countries quite slowly
so that there is little tendency for convergence to
take place. Others argue that the process is swifter
(Barro and Sala-I Martin, 1995; and Grossman and
Helpman, 1991).
New Growth theory is closely associated with
American economist, Paul Romer. A central
proposition of New Growth theory is that, unlike land
and capital, knowledge is not subject to diminishing
returns.
The importance of knowledge
Indeed, a focus on the development of knowledge is
seen as a key driver of economic development. The
implication is that, in order to develop, economies
should move away from an exclusive reliance on
physical resources to expanding their knowledge
base, and support the institutions that help develop
and share knowledge.
 Governments should invest in knowledge because
individuals and firms do not necessarily have private
incentives to do so. For example, while knowledge is
a merit good, and acquiring it does not deny
anyone else that knowledge (the principle of
nonrivalry of knowledge), its usefulness to individuals
and firms may be undervalued, and yet knowledge
can generate increasing returns and drive economic
growth. Government should, therefore, invest in
human capital, and the development of education
and skills. It should also support private sector
research and development and encourage inward
investment, which will bring new knowledge with
it.
The role of the public sector
Because ‘public’ investment in social capital is subject
to market failure, New Growth theorists argue that
government should allocate resources to compensate
for this failure.
Public Utilities and infrastructure

Essential utilities like electricity, gas, and water are

natural monopolies, and in many countries are
provided by the public sector. However, if these
utilities are under-supplied due to inadequate public
funds, the private sector will suffer and growth will be
limited. This is because the industrial sector relies on
energy and water for its production and distribution,
without which it will not produce efficiently or
competitively. The accumulation of private capital,
therefore, depends up the correct level of expenditure
by government.

Similarly, New Growth theorists argue that

government should also finance, or seek finance for,
infrastructure projects, such as road, rail, sea, and air
transport. Such projects involve the creation of
quasipublic goods, and the theory of market
failure suggests that they would be ‘under-supplied’
without government. The huge fixed costs and the
difficulty of charging users prevents the private sector
supplying, and the state may choose to act like a
producer and financier, and provide necessary
legislation for and co-ordination of such projects.

These projects also generate positive externalities,

and as such justify government involvement. For
example, an improved infrastructure increases the
likelihood of tourist revenue as well as reducing
production costs.
ECONDEV WEEK 1 MIDTERMS LEARNING CONTENT
Introduction:
The pace of economic growth and structural change in
many Asian countries in the past thirty to forty years
ranks as one of the most outstanding features of recent
world economic history It has been termed the “Asian
growth miracle.” Why have the Asian economies
flourished whilst other developing countries and
regions have not? Incomes in developing Asia have
grown much faster for a sustained period of time-up to
four decades-than they have anywhere else in the
world. These economies were able to move from a very
low level of economic activity in the late 1950s and
early 1960s, to fairly high levels of per-capita income,
much faster than most of the industrial countries
outside Japan were able to do during their rapid growth
phases.
What were some of the characteristics of this
spectacular growth performance in Asia and what were
the policies that contributed to it and supported it?
Lesson Proper:
THE ASIAN GROWTH MIRACLE
Many aspects of the growth theories described do
apply to the Asian experience, though each is not fully
sufficient to adequately explain the ‘miracle?’ In the
following section, we look at the various aspects that
may have supported such rapid growth.
In what follows, we adopt the approach suggested by
Quibria (2002), grouping the explanations for the Asian
“miracle” into primary and secondary factors. The
primary factors were present in all the “miracle”
economies at the time of their economic takeoff. The
World Bank (1993) study identified the countries falling
into this classification to be Japan, the NIEs (Singapore,
Hong Kong, Taiwan, and Korea),
Indonesia, Malaysia, Thailand, and China. The primary
factors in these countries form the common
denominator of the Asian growth experience and they
are the fundamental determinants of sustained rapid
growth during the period. They are mutually reinforcing
and therefore constitute a bundle of characteristics or
factors that cannot be easily separated.
In addition, there were secondary factors that were
sometimes present and sometimes not. They
contributed to the “miracle” of rapid growth but they
varied from country to country. They added richness
and variety to the growth experience. In analyzing the
growth experience of the “miracle” economies, it is
important to distinguish the policy environment that
existed during the early stage of the economic takeoff
to sustained high growth and the economic
performance that resulted from the mix of policies. To
do this, it is useful to describe the dynamics of the
growth process that resulted in such outstanding
growth performance.
PRIMARY FACTORS
First Primary Factor: Importance of
OutwardLooking Policies and the Emphasis on
Exports and Foreign Direct Investment
As with other developing countries, the economies of
East and Southeast Asia started the industrialization
process by developing import-substituting industries.
They included industries that were natural
complements to the agricultural base that already
existed, such as food processing, textiles and apparel,
and footwear. There was also a push toward medium
and heavy industries in several countries, including
Korea and India. During the 1960s, development
economists and policymakers stressed the importance
of developing a wide range of domestic industries that
could supplant imports. This line of reasoning was
termed “bootstrap” development. It was also popularly
believed that the developing countries would need
large inflows of development assistance to supplement
domestic saving in order to accomplish this
transformation of the production structure. India took
on board these suggestions and began to develop a
wide range of domestic industries with the help of the
Soviet Union.
Other countries in Asia were more reluctant to follow
this model completely. Instead, they turned to Japan as
an example of how to industrialize. Japan in the 1960s
was building a strong industrial economy based on
exports. It had achieved industrial maturity in the 1930s
and it returned to this model of development after
World War II, with the difference being that it targeted
much of its production at foreign markets. Korea,
Taiwan, China and later, the major economies of
Southeast Asia, followed this model. Soon after
developing some industrial capacity in
importsubstituting industries, they turned their
attention to external markets. In Korea, the model was
followed most closely as the industrial conglomerates,
called chaebol, were modeled on the Japanese
industrial giant kareitsu, such as Mitsubishi and later,
Sony and Honda. In Taiwan, the model was adjusted to
stress the development of small and medium industries
and the network of overseas Chinese in the rest of
Southeast Asia, particularly Hong Kong and Singapore,
but .also in Europe and North America. The emphasis
was initially on apparel, which shifted quickly to
electronics.
In the Southeast Asian countries of Malaysia, the
Philippines, and Thailand, the initial emphasis was on
agriculture-based exports such as rubber, sugar,
coconut and palm-oil products, and textile fabrics, such
as silk. In Malaysia, large rural estates were mobilized
to increase production, together with research to
increase productivity. Slowly, the emphasis on
agriculture-based industry gave way to the
development of labor-intensive industries, including
apparel and footwear and later, electronics assembly.
The emphasis on exports was facilitated by government
policies, which varied from country to country.
One of the common threads of these policies was that
there was initial protection of these industries through
a combination of import restrictions and tariffs so that
resources would be allocated to them by the private
sector in anticipation of good profit potential. However,
these taxes were lower in East and Southeast Asia than
they were in South Asia and other developing regions.
More importantly, they were reduced over time to
minimize the distortions in the allocation of resources
that were created. In South Asia, tariffs were also
reduced but it took a longer period of time to do so,
resulting in a much slower transition to export
promotion from import-substitution, leading to waste
and misallocation of resources.
Tax rates and trade distortions are shown in Table 3.3
where two measures of trade taxes are reported. The
first, taxes as a percentage of exports and imports, may
understate the degree of protection, particularly if
taxes are high since there will be less trade in these
products. On the other hand, the average tariff rates
may overstate the degree of protection for the same
reason since most trade occurs in products that are
taxed at low rates. Nevertheless, both sets of figures
show that there has been a deceleration in the level of
taxation, particularly since 1990. Even in South Asia
where rates were high in 1980 and 1990, the rates fell
in the decade of the 1990s and 2000s. The challenge in
South Asia is not only to reduce the rates of taxation,
but also to find other revenue sources to replace the
tax on trade and also to reduce the level of nontariff
barriers, which are not only difficult to measure but
also restrict trade. Here we are speaking of
bureaucratic procedures and slow processing that
increase costs and reduce efficiency.
The transformation to labor-intensive industrialization
with an emphasis on exports was supported by the
inflow of foreign direct investment, initially in small
amounts from Japan and the United States, and later in
greater volume, particularly from Japan as it
accelerated the movement of its labor-intensive
industries offshore when the yen appreciated in value
in the second half of the 1980s and early 1990s.
The combination of a shift toward export promotion
policies combined with reductions in tariff rates and
complemented by the inflow of foreign direct
investment and supportive macroeconomic policies
produced an export boom that lasted more than
twenty years, unprecedented in economic history. The
ratio of exports to GDP increased by leaps and bounds.
The proportion of exports derived from manufacturing
also increased dramatically and employment shifted
from agriculture to industry, as did value added (see
Table 3.4). By 2000, more than 50 percent of GDP was
generated by the export sector in all the East and
Southeast Asian countries except Korea, Indonesia, and
the Philippines (see Table 3.5). Hong Kong and
Singapore have had the highest GDP percentage share
of exports in the region historically and currently; it
went up to 207 and 231 percent respectively, in 2007.
Indonesia, which was slow to start industrializing
because of its earlier dependence on oil, and China.
which was also late in starting and is a very large
economy with a huge domestic market, were exporting
less than 50 percent of GDP.
In South Asia, on the other hand, the rate of export
expansion was modest until the 1990s when trade
liberalization policies were adopted' in several
countries. Figures in Table 3.5 show that by 2000,
exports of India, Pakistan, and Sri Lanka were generally
only one-third (around 15 percent of GDP) of most
countries in East and Southeast Asia, except for Sri
Lanka which exhibited slightly higher export figures of
40 percent.
In this region, Sri Lanka is an interesting case where
agricultural exports, particularly tea, were extremely
important in the early years. However, despite more
open export policies than its neighbors (mean tariff
rates are not significantly higher than those in Thailand
or China), Sri Lanka has been unable to develop a
strong industrial base because of domestic constraints
and a poor climate for foreign investment as a result of
civil unrest.

THE ROLE OF TECHNOLOGY Technology also
played a crucial role as the “miracle” economies moved
to higher levels of income and development. Growth in
income is a function of the growth in inputs and the
TFP residual, and this residual is largely a function of
improvements in technology. The developing
economies in Asia have been able to access new
technology in three major ways:
1. by buying it from foreign companies under
license;
2. by copying it without license; and
3. by entering into a joint venture and importing
the technology through foreign direct
investment.
In recent years much of the transfer in technology has
been through foreign direct investment.
FOREIGNTECHNOLOGY Early on, the newly
industrialized economies attracted and used foreign
technology, but mostly through license. Japan and
Korea, in particular, did not encourage foreign direct
investment in their economies. Instead, they sent
missions overseas to learn about the most up to date
technology and then copied it. Much was spent on
research and development for the adoption of overseas
technology in local industries and efficiency improved
as a result. Automobiles are a good example. Later, the
countries of Southeast Asia bought technology from
other countries through the process of foreign direct
investment. The amount of investment that flowed into
the Asian economies increased rapidly following the
Plaza Accord when the industrial countries agreed to
enter foreign exchange markets to boost the value of
the yen. This caused many industries in Japan to lose
competitiveness. As a result, these firms, mostly in
labor-intensive manufacturing and electronics, moved
offshore to lower-cost locations in Southeast Asia and
China. The amount of foreign direct investment
increased rapidly as a result (see Table 3.6).
Second Principal Factor: Macroeconomic
Policies and the Role of Government
Unlike those countries that followed import-
substituting industrial policies, the East and Southeast
Asian economies succeeded because their general
policy thrust was to clear the way for markets,
competition, and contests for resources to play the
lead role in the allocation process. Governments
supported this market-led development through the
pursuit of prudent fiscal and monetary policies,
including a low inflation environment, an emphasis on
human resource development, the provision of physical
and social infrastructure, and the maintenance of a
legal framework, essential for a market system to
function smoothly. The levels of government financial
deficits were generally low and government borrowing
was held at prudent levels. In South Asia, budget
deficits tended to be higher. Nevertheless, inflation was
generally not a problem that had to be addressed on an
ongoing basis as it was in Latin America (see T able 3.7).
The governments of the day in the Asian economies
were thus also important players in the pursuit of
higher rates of growth and development. The success
of these economies was not particularly sensitive to the
amount of government intervention in the
microeconomic aspects of the economy. Government
intervention in the industrial and financial sectors was
heavy in Japan, Korea, and Singapore, moderate in
Malaysia and Taiwan, and relatively weak in Hong Kong
and Thailand. Yet all these economics grew rapidly. In
the Philippines and Sri Lanka, the policy environments
were similar to the more successful economies but
growth was slowed by political uncertainty and
domestic unrest. In Indonesia, growth was slowed by
the early reliance on oil and later by the demise of a
single political regime that had been in place for more
than thirty years. The effectivity in achieving broad
economic stability, export promotion, and tariff
reduction and a neutral position toward agriculture
combined with outward-looking policies that attracted
foreign direct investment and technology transfer were
more important than specific industrial, financial and
trade policies in stimulating growth.
It is true that some policies, such as financial repression
and directed government lending programs, were not
particularly beneficial and caused resources to be
allocated inefficiently. However, the flow of resources
available for investment was quite substantial, but
because of the high domestic saving rates and the
inflow of foreign capital, these shortcomings were not
recognized until the growth bubble of the early and
mid-1990s burst in 1997.
What did seem to be important were incentives for the
technocrats that ran the government bureaucracy. The
experiences of Singapore and Taiwan are notable. In
both countries, civil-service wage levels are comparable
to those of the private sector so that the most qualified
people can be recruited. Promotions are based on
merit, not patronage. Finally, there is a strong anti-
corruption culture. Conversely in several other
countries, salaries for civil servants remain low. Such a
system attracts those looking for rent-Seeking
opportunities and the environment creates a fertile
seedbed for corruption and influence peddling. Even
where salaries are high, as in Japan, incentives to
perform efficiently are eroded by a system where
promotions are made strictly on a seniority basis and
rewards are made accordingly.
Third Principal Factor: Education, Labor-Force
Growth, and Labor Productivity
Labor productivity in Asia increased rapidly as did total
productivity. To a great extent, this was due to the
increase in the amount of capital per worker as a result
of rapid investment growth and technological transfer.
Another significant factor that has influenced increased
productivity in the region is the high level of investment
given to educating the workforce. Asia has a very
literate workforce that makes them highly adaptable to
technological changes. In addition, high population
growth, particularly in the labor force, was an
important source of economic development. Bloom
and
Williamson (1999) estimate that up to 25 percent of the
increase in Asia’s growth from the 1960s onwards can
be attributed to high rates of expansion in the labor
force. The education and training of this rapidly
growing workforce was, in turn, crucial to growth in
productivity.
ROLE OF EDUCATION Historically, the role of
capital and saving to facilitate capital equipment
purchases has been stressed as the primary engine of
economic growth. We see this in the models of Harrod
and Domar (1939, 1946) and also in the Solow and
Swan (1956) models, even though the latter models
emphasize the role of total factor productivity.
However, as discussed earlier, a number of economists
have recently stressed the importance of education.
For example, the Nobel prize winner Robert Lucas
(1990) and other proponents of the “new growth
theory,” including Mankiw and Romer (1991), and
Mankiw, Romer, and Weil (1992) suggest that
education is even more important than physical capital
in raising the rate of growth. Lucas argues that by
continuously shifting to products requiring higher skills,
the Asian economies were able to raise productivity at
a very rapid rate. Countries that remained chained to a
set technology, such as some countries in Africa, Latin
America, and South Asia, were not able to take
advantage of increases in productivity as the NIEs and
the Southeast Asian countries did. These countries
were very open and subject to the changing forces of
comparative advantage. This forced them to
continuously adjust their product mix as wages rose
and their comparative advantage shifted. The secret
was in the shifting mix of production, not in their
having a better skill or education mix than other
developing countries, although skill development was a
necessary condition for this shift to be achieved.
For example, Table 3.8 shows that there has been a
gradual increase in the human development index (HDI)
of countries in the Asian region, and it had reached a
high level by the late 1980s. Even as early as 1980, with
the exception of China, the countries of East Asia had
high literacy rates for both men and women (see Table
3.9). Literacy rates were somewhat lower in Southeast
Asia, although they were over 90 percent in Singapore,
the Philippines, and Thailand. In South Asia, literacy
rates were much lower, with the exception of Sri Lanka.
During the next twenty years, there were further
improvements in education as enrolment rates in
secondary and tertiary education increased. However,
by the year 2000, some of the educational advantages
over comparable countries at the same level of income
had eroded (this is partially reflected in Table 3.8 by the
declining HDI values relative to GDP in several Asian
countries during the decade). There were two reasons
for this. First, the amount of public resources needed to
boost the enrolment rates in secondary and tertiary
increased rapidly' because the cost per student was
higher compared with primary education. Secondly, as
the incomes of the Asian economies rose, they had to
face competition from a set of countries that also had
high per-capita incomes and a more educated
workforce.
The decline in the ranking of the Asian economies in
the HDI between the 1990 and 2000 rankings also
suggests that the rate of growth income tended to
increase more rapidly for the Asian countries compared
with the overall HDI. This is particularly noticeable for
China and Indonesia in East and Southeast Asia, and
also for Sri Lanka in South Asia, where the decline was
quite precipitous (see Table 3.8). In the latter case, the
lack of resources devoted to education and other social
sectors is understandable, given the civil disorder that
occurred for much of the decade.
Nevertheless, despite these favorable results,
comparisons with other developing countries do not
show that the educational attainment in the Asian
economies was significantly higher than that of other
developing countries. Behrrnan and Schneider (1994)
note that the “miracle” economies had higher primary
and secondary school enrolments in 1965 than the
international average after controls for per-capita
income were imposed. More than two decades later,
only Korea and Indonesia had exemplary enrolment
rates relative to the international average. They
conclude that the “miracle” economies as a group did
not have an unusually high schooling attainment
despite many years of rapid growth.
This leads to the conclusion that education has to be
taken together with labor-market flexibility and the mix
of skills developed to deal with a rapidly changing
production schedule.
This aspect is illustrated by the case of the Philippines,
which had a very high level of human capital
development in the 1950s and 1960s. However,
because it was unable to put together a matching set of
development policies that could take advantage of this
highly skilled workforce, it developed slowly and
fitfully. Political instability was reflected in the
macroeconomic policies that were not conducive to
attracting a large inflow of foreign investment, and
when they were able to maintain high growth rates for
a time in the late 1960s and 1970s, the government
introduced a series of controls and agencies that
squandered revenues. Furthermore, the Philippines
had difficulty overcoming a protectionist lobby that
favored local big businesses.
Fourth Principal Factor: Labor-Market
Flexibility
The “miracle” economies had very flexible labor
markets at the beginning of their growth spurt and this
continued throughout the period of rapid growth
almost unabated. According to the International Labor
Organization (ILO), the “miracle” economies are among
the most flexible in the developing world. While there
can be disagreements about the desirability and extent
of market interventions in the labor market to deal
with safety, health, norms for compensation, and child
labor, there is little doubt that excessive labormarket
regulations have a negative impact on economic
development and growth. Regulations raise the cost of
labor, diminish employment, and reduce the flexibility
of firms to hire and fire. The result is that while those
who are employed benefit from the regulations, there
are negative impacts on the rest of the labor force,
including the poor. The “miracle” economies were able
to achieve rapid growth in real wages without
protective labor legislation. Korea, for example, which
joined the Organization for Economic Cooperation and
Development (OECD) in the late 1990s, did not have a
minimum wage policy until 1988.
The bundle of these four policies resulted in a number
of important macroeconomic developments, including
rapid growth and reduction in poverty. These factors,
particularly high saving and investment, and increasing
productivity, are discussed in the next two sections.
SECONDARY FACTORS
Initial Secondary Factor: Difference in Initial
Conditions
Several other factors have been discussed in the
literature as possible explanations for the growth of the
“miracle” economies and they also deserve mention.
They include initial conditions and sector policies.
Initial conditions played an important role in providing
a fertile seedbed for development to germinate. The
successful East Asian economies differed substantially
from other deve10ping economies of Asia in the 1960s
in two fundamental respects. First, the subsequently
successful countries were by and large better endowed
than others in Asia in terms of the quality of their
human resources. Secondly. income, wealth, and land
were also more evenly distributed in these Asian
economies in the early 1960s than they were in other
Asian countries. In the aftermath of the Korean War
and following the migration of large numbers of people
fleeing the Chinese mainland, land reforms were
undertaken in these two countries that brought about
greater equality in the distribution of land and capital
resources. At the same time, both of these economies
had benefited from strong educational policies in
earlier years that resulted in higher levels of human
resource development, including nearly 100 percent
literacy, a high completion rate in elementary school,
and high enrolment rates in secondary school (see
Tables 3.9). In China, there was also strong emphasis on
education and equality of opportunities so that when
the economy opened up to Western ideas in the 1980s,
it had a
strong and well educated labor force. In Southeast Asia,
the Philippines had been the beneficiary of assistance
from the United States that strengthened the
education system in the colonial period, and this
emphasis on education continued after independence.
In Thailand, the monarch controlled some land but
there had historically been a policy of relatively even
land distribution. As the urban elites made more
money in the 1980s and 1990s they bought up land and
the distribution of resources became more unequal.
This was exacerbated by the lack of secure title and
land tenure laws that required tenants of cleared land
to work the land or else risk confiscation.
Another Secondary Factor: Importance of
Sector Policies
AGRICULTURAL SECTOR POLICIES In general,
as industrialization proceeds, there is a tendency to
pursue policies that favor the industrial sector at the
expense of agriculture. This is only natural since in the
initial stages of industrialization, taxes on agriculture
make up the major source of revenue for the
government. The risk in following such a policy of
taxing agricultural exports and the agricultural sector in
general, is that it is not a sustainable long-term strategy
because it results in the eventual strangulation of that
sector, a reduction in output growth, and stagnation of
the rural economy. Because the growth in industrial
sector employment is never enough to offset such a
loss in income and employment, this type of policy will
eventually result in the collapse of aggregate demand
and industrial stagnation, even if there is a viable
export market. In this case of the Asian economies,
there was first a gradual and then more rapid increase
in the rate of saving and private investment. This
provided resources to fund industrial development and
reduced the necessity for taxing the agricultural sector
excessively. While an anti-export bias did exist for
traditional exports from Malaysia, Thailand, and other
East and Southeast Asian economies it was modest. In
the case of Thailand, the tax on rice exports created
incentives for diversification of the agricultural base to
crops with greater profit potential. Furthermore, the
Green Revolution was instrumental in raising rural
incomes. It was also supported by large amounts of
public investment, particularly to extend the amount of
irrigated areas.
INDUSTRIAL POLICIES The term “industrial policy”
in the context of the development of the “miracle”
economies is taken to mean government policies that
were designed to promote particular subsectors,
usually capital-intensive industries. These industrial
policies included subsidized credit and other policies
designed to promote these industries so that they
could compete effectively in international markets.
These policies became an integral part of the policy
apparatus.
Only Korea and Taiwan adopted comprehensive
industrial policies. In the other economies, industrial
policy was not adopted in a systematic way nor was it
particularly important in influencing the evolution of
industrial growth and concentration. There was
government intervention in most of the other
economies but they were sporadic and not well
coordinated over time. In Malaysia, there was an effort
to support heavy industry in the 19805 and a high-tech
push sponsored by the Minister of Industry, Dr. Habibi,
in the early 1990s. However, these efforts did not
increase international competitiveness and were
interpreted by observers as political favors to
supporters and, as a result, arbitrary without any well
formulated economic objective. In Thailand,
Christensen et al. (1997, p. 346) Observed that Thai
sector policies “were not guided by a strategy of picking
winners and have often been marked by patronage and
rent-seeking.
The policies in Korea and Taiwan were, on the other
hand, systematically thought out. Subsidies were
withdrawn if certain performance criteria were not met
and there was a vigorous effort to keep the favored
industries on track to become competitive in external
markets.
Whether these industrial policies in Korea and Taiwan
were successful or not has been the subject of
considerable research. There is still no uniform
agreement on the subject. Little (1996) concluded that
it was most plausible that Korea grew despite its
industrial policies, while Pack (2000) concluded that
industrial policies played a minor role in stimulating
growth and should be viewed cautiously, particularly in
light of the adverse effects of such policies on the
financial sector (see also Chapter 8) and other sectors
that had been neglected.

ASPECTS OF ECONOMIC PERFORMANCE IN
THE ”MIRACLE” ECONOMIES
1. High Growth Rates of Saving and Investment
Rates of saving and investment increased dramatically
in many countries in Asia, from paltry levels of 10
percent or less in Korea and Singapore, and somewhat
higher levels elsewhere in 1960, to over 30 percent by
the 1990s. This achievement is unprecedented in the
annals of economic history. To give some idea of the
magnitude of this accomplishment, consider the
average saving rates for the OECD countries and other
developing economies (see Table 3.10). Hong Kong and
Malaysia had high saving rates in 1960. Other countries
in Asia, for which data are available, recorded saving
rates below 20 percent, and often, below 15
percent. By 1970, saving rates had risen, but were still
below 20 percent in all but six developing economies
shown in Table 3.10. By 1990, all economies in East and
Southeast Asia had saving rates of over 30 percent
except Taiwan and the Philippines. In South Asia, the
record was less spectacular but still impressive.
Bangladesh, India, and Nepal all raised their saving
rates over the period of four decades. By contrast, the
saving rate in the United States was never more than
20 percent and was on a declining trend throughout
the period, while Japan’s saving rate was relatively
stable, although it also began to fall in the 1990s.
Apart from the issue of efficiency, the rapidly growing
rate of saving was instrumental in providing the
resources for the high growth rates achieved in the
Asian region in the past few decades. As investment
rates were also high, the resource gap among the Asian
countries was insignificant. In East Asia, China, Hong
Kong, and Taiwan have had an excess of saving over
investment since 1980 (see Table 3.11), with the
exception of Korea whose saving-investment gap
moved from a deficit to a surplus by 2000. In Southeast
Asia, Singapore and Thailand moved to a surplus in
2000, while Indonesia and Malaysia had surpluses for
all the available years displayed in Table 3.11. The
Philippines had deficits in 1980, 1990, and 2000. In
South Asia, India has moved between small surpluses
and deficits while Bangladesh, Pakistan, and Sri Lanka
had substantial deficits in 2007.
2. Increased Productivity
Beyond the increases in saving and investment, it is
likely that improvements in the efficiency with which
these resources were used also contributed
significantly to the growth in the Asian nations. For
comparison purposes, we will first examine estimates
of total factor production (TFP) for the industrialized
nations. We begin with a caveat that the estimates are
sensitive to the accuracy of the variable inputs
measured. If the contributions of labor and capital to
the growth process are underestimated, then the value
of TFP will be overestimated.
The initial estimates of TFP made by Solow and others
for the industrial countries were very large, (that is, the
inputs of labor, capital, and land, measured in a simple
fashion, grew much more slowly than, output). The TFP
component accounted for as much as 60 percent of
total output growth. Conventional factors of
production accounted for the remaining 40 percent.
Initial work on TFP in the late 1980s led to tension
between the World Banks view and that of the wider
academic community, as represented by Alwyn Young
(1992, 1995), Lawrence Lau (1996), and others. The
World Bank made a case for a high level of TFP in Asia.
Young and Lau disagreed with this, saying that growth
in Asia was primarily due to the rapid accumulation of
physical capital and labor.
Recent research suggests that many of the differences
in opinion can be reconciled by looking at assumptions
about the shares of capital and labor in income. Lower
assumptions of capital shares result in higher estimates
of TFP. Moreover, estimates of TFP have been rising
over time as the region opened its borders to foreign
investors and the rate of technological transfer
increased. This has been reinforced by the rapid growth
of the region between 1985 and 1997. This period, the
beginning of which coincided with the Plaza Accord,
where the Group of Seven (G7) industrial countries
agreed to support a yen appreciation, also
corresponded to a period of rapid inflow of foreign
direct investment and rates of technological transfer.
Sarel (1997) shows that the average rate of productivity
growth in the late 1980s and early 1990s was 3.2
percent for the MRS. This is considerably higher than
the rate of just over 2 percent for the period 1970-
1985. Similar results were recorded by Bosworth and
Collins (1996), who found a “U shaped” pattern of
productivity growth for the three periods 1960-1973,
1973-1984, and 1984-1994. In the last period, TFP
contributed a substantial fraction of total output
growth in all the Asian economies. While not as high as
the TFP figures obtained for the industrial countries,
they are still quite high when compared with the
estimates reported by Young (1992, 1995), and Kim and
Lau (1994). They are in excess of 45 percent of the
overall growth in output per worker in Taiwan,
Singapore, and Thailand, and between 30 and 45
percent in Malaysia and Korea.
THE POLICY MATRIX AND ECONOMIC “miracle” economies and East and Southeast Asia in
PERFORMANCE IN SOUTH ASIA both educational attainment at the secondary and
tertiary levels, and in labor-market skills and rates of
literacy.
Growth in South Asia was considerably slower than in
Macroeconomic policies in South Asia were generally
the “miracle” economies during the postwar period.
stable-inflation rates were not high and variable and
There are a number of reasons for this and we can only
government deficits were not excessive. There were
speculate what might have happened if they had
exceptions, including the fiscal crisis in India in the early
adopted open and outward-looking policies at an early
1990s. But the record was generally good and certainly
stage in their development. In terms of the bundle of
better than in other developing regions such as Latin
four primary policies that were responsible for the
America, where high rates of inflation and
rapid growth of the miracle economies, there are
macroeconomic instability have been endemic.
obvious differences between these policies and those
pursued in South Asia. Industrial policies were adopted that gave subsidies to
several industries but these policies were generally
The South Asian economies were generally not open to
unsuccessful in promoting rapid growth, neither in
trade and to the inflow of foreign direct investment.
exports nor in achieving economic efficiency. This was
Sabhs and Warner (1995) developed an openness index
because the subsidized industries did not have to meet
based on four aspects of trade policy, classifying an
the market test of competing in international markets.
economy as open if it had import duties that were less
Furthermore, they were not sanctioned if they did not
than 40 percent, quotas covering less than 40 percent
meet production and efficiency targets. As a result, a
of imports, a black market exchange premium of less
large but relatively inefficient industry sector
than 20 percent, and an absence of a state monopoly
developed. In addition, the mix of subsidies and
for major exports. They also defined an open economy
directed credit in South Asia also weakened the
as one without a socialist government. According to
competitiveness and allocative efficiency of the
this categorization, none of the South Asian economies
financial system.
was open during the postwar period apart from Sri
Lanka and Nepal in 1992. Conversely, all the “miracle”
economies were open throughout the period between
CONVERGENCE OF INCOME
1950 and the early 1990s, when Sachs and Warner
ended their data series. Because the South Asian We conclude this section on the Asian growth
countries were not open to trade, there were also very experience of income. Whether countries from the
limited inflows of foreign direct investment until very lower end of the development spectrum will ever catch
recently. up with the development levels of the more advanced
and more industrialized economies at the high end of
South Asia had generally inflexible labor markets even
the spectrum is often a question of interest to both
though there were high levels of unemployment. This
theoretical and applied economics. The answer to this
was particularly true in the formal sector. For example,
question holds the key to determining which economic
according to the Global Competitiveness Report of
development and growth strategies are most
1998, although India ranked high in terms of the quality
appropriate at particular points in time. From the
of its labor force as reflected by the number of
review of the Asian “miracle” in the previous section, it
engineers, scientists, and others with technological
seems that the prospects for convergence within this
backgrounds, it ranked near the bottom in terms of
group of countries are good. However, for other
labor-market flexibility. Labor unions were strong and
regions this may not be the case.
job security was high, particularly given the level of
economic development. This situation was generally In order to understand the issue of convergence better,
true in the other countries in South Asia too. As a we shall discuss some basic concepts relating to the
result, they were not able to respond quickly to shifts in convergence of income.
demand according to the change in skill mix required
when demand shifted to higher-skilled occupations. 1. Absolute Convergence
The hypothesis that poor countries tend to grow faster
per capita than rich countries-without conditioning on
The educational attainment of the workforce in South any other characteristic of the economies-is referred to
Asia was, until recently, much lower than in the as absolute convergence. The Solow model says that all
“miracle” economies (such as Hong Kong and economies will converge to the same level of percapita
Singapore). This is evident from comparisons of literacy capital and per-capita income irrespective of where
and school enrolment rates in the two economies (see they started out. This would be true even with technical
Table 3.12). In South Asia, there has been some progress, since the technical progress coefficient is
improvement in recent years, particularly in the 1990s. assumed to be constant across all countries.
Nevertheless, these countries generally lag behind the
Is this realistic? Has there been this kind of
convergence either within countries or across
countries. Let us look at the evidence;
First, if this kind of convergence is to take place, then
the poorer countries with lower levels of capital per
capita will grow faster. They are closer to the origin of
the phase diagram in Figure 3.4.
Using this inference from the Solow model, we can test
whether such a relationship exists, that is, is there a
relationship between per-capita income in an initial
period and growth over an extended period from that
initial date. Most studies have worked with logarithmic
functions. This is done so that a linear relationship
between levels and growth rates can be established
and tested through regression analysis.
However, the convergence hypothesis does seem to
hold if a more homogenous set of countries is
considered. In the OECD after 1950, the poorer
countries (those in the bottom half of the distribution
in 1950) grew by over 1 percent faster than the rich
countries in the top half. Those in the bottom quarter
grew more than 2 percent faster than those in the top
quarter. The dispersion of income fell.
2. Conditional Convergence
A more general approach than absolute convergence is
called conditional convergence. In conditional
convergence, various parameters are allowed to
change between different countries or groups of
countries. If saving rates, depreciation rates, and
population growth rates differ among countries, the
levels of income may differ, although the Solow theory
would still predict that there would be a convergence in
growth rates of income. Nevertheless, the steady state
levels of income would differ.
There have been many studies on conditional
convergence but we will not go into them in detail
here. Suffice it to say that they cannot completely
explain the differences in growth rates among a wide
set of countries. One difficulty is that heterogeneity in
the data set would require the use of different
regression models for different subsamples (see Ardic,
2002). On the plus side, variations in the saving and
population growth rates can explain more than half of
the variations in per-capita income across countries.
However, the magnitude of the coefficients on these
variables is too large to be consistent with the Solow
model. This result implies that the effect of diminishing
returns is very small. It takes many decades for the
effect of diminishing returns to set in.
For all intents and purposes, the Harrod-Domar (1939,
1946) model seems to be a better predictor of the
actual evolution of income growth. Yet we know that
the Harrod-Domar model is much too simple. What is
more likely is that several countervailing factors are
working simultaneously to make it appear as if the
saving rate and the capital-output ratio alone
determine income. There may be a steady state but it is
continually being shocked by changes in some of the
variables. One thing that could be happening is that
shifts in technology have the effect of boosting returns
to scale, offsetting the tendency for diminishing returns
to set in. Furthermore, if technical progress does not
spread uniformly across countries, then the rich
countries will continue to have an ever widening edge
over the not so rich. A branch of the new growth theory
explores these issues in more depth.
ECON (WEEK 2) Introduction
The steady growth of the Asian economies was
abruptly interrupted by the financial crisis that beset
the region in 1997. In July that year, the Thai baht was
attacked, primarily by currency hedge funds. These
funds became active in four Southeast Asian currency
markets in June=September 1997, setting off a chain of
competing devaluations that blew up into a regional
financial crisis. A feature of these competing
devaluations was the sequencing of the devaluations;
the Thai baht first began to decline in June 1997, and
was followed by the Malaysian ringgit, the Indonesian
rupiah, and the Philippine peso in July.
The devaluations subsequently spread to the Australian
dollar and the Korean won in October. The Hong Kong
dollar was also attacked in October and while the
currency parity with the US dollar was maintained, the
stock market fell by about 30 percent of its value in a
week. The depreciation of equity indices denominated
in US currency, shown in Table 4.1, reflects the changes
in exchange rates. From January 1, 2007, until mid-
November that year, the depreciation in equity indices
denominated in US currency was more than 30 percent,
in one case around 25 percent, and around 10-12
percent for the rest of the countries outside Japan.
These currency devaluations were substantial,
particularly when it is recognized that the bulk of the
devaluations took place from July. The implications for
the financial and stock markets, and on the
components of aggregate demand and international
trade, are discussed in subsequent sections.
Table 4.1 Change of Asset Prices, 1997
Restrictions imposed on the equities markets
exaggerated the price declines. In Thailand and Korea,
restrictions on foreign investment induced portfolio
formation whereby individual stock selection was
limited. When markets declined, there was a tendency
to reduce the entire country’s portfolio weighting to
zero, rather than follow a selective approach. Malaysia
exacerbated its equity market’s decline by imposing
price limits on the run.
 developments in the external sector that led to a rapid
increase in the current account deficit a real exchange-
rate over valuation and a consequent decline in export
competitiveness and earnings. The third is the
spillover or contagion effect whereby pressure on the
currency and financial markets spread from country to
country, exacerbating the crisis and weaknesses in the
financial sectors of the various economies.

1. The Bubble Economy

The lack of hedging facilities in many Asian countries
meant that investors had no alternative but to reduce
their country portfolio weighting to zero. While the
withdrawal of foreigners from these markets may have
played a key role, it is important to remember that
these stock market declines were primarily due to a
herd instinct. In most of these countries, the stock
market ownership is largely local (over 75 percent in
Malaysia, South Korea, Taiwan, and Thailand). Only in
Indonesia and the Philippines, where local ownership is
less than 50 percent, are the stock markets dominated
by foreign holdings. The ramifications of these dramatic
declines in equity prices will be further explored in the
succeeding sections both in terms of their effects on
consumption and investment components of aggregate
demand but also in terms of their effects on the
balance sheets of business firms and the financial
sector.
All the countries in Southeast Asia (including the
Philippines which started from a low base) grew very
rapidly during 1994 and 1995. Export performance in
1995 was spectacular and economic growth was
generally higher than expected. The huge inflow of
foreign capital was channeled into both fixed
investment and equity portfolios. The current-account
deficits widened and stock markets boomed. Stock
market exposure is relatively hard to document but it
was high, particularly in Malaysia and Korea where. as
in Japan, shares were widely held by business
enterprises. This left them vulnerable to a shift in
investor sentiment and in a tenuous position if stock
prices fell.
Under the fixed exchange-rate regimes followed by all
these countries, the inflow of foreign capital was
generally translated into an expansion in money supply
and lending growth. Bank credit to the private sector,
particularly in relation to gross domestic product (GDP)
growth, rose dramatically in most of these economies
with the exception of Korea (see Table 4.2).

Lesson Proper: Table 4.2 Growth of Bank Credit to the private Sector
Relative to GDP Growth
WHY DID IT HAPPEN?

There are several explanations for the financial crisis

but none of them is completely satisfactory. A worrying
aspect of the crisis is that no one anticipated its extent
nor its prolonged nature. However, if we look at history
this has always been the case. The great stock market
crash of 1929 was not anticipated by many nor was the
1987 Wall Street collapse. There were signs of a
disequilibrium build-up in all the Asian economies,
particularly Thailand, which had been warned by the
International Monetary Fund (IMF) to take control of its
ballooning external debt. However, the fury of the
currency speculation and the widespread collapse of
financial markets took everyone by surprise.

Three alternatives and even complementary

explanations for the crisis are reviewed in this topic.
The first is the stock market, real estate, and bank
credit bubble that had developed in the first half of the
1990s. These developments combined with a reliance
on short-term external borrowing and a belief that the
US dollar to local currency parity would be maintained,
resulted in a highly leveraged and vulnerable financial
sector that caved in once currencies came under attack
and confidence waned. The second is a series of
Inflation also began to rise but because these
economies were relatively open, price increases Yew
much more apparent in non traded goods. Real-estate
prices rose dramatically alongside similar increases in
equity prices. Wages also began to rise in the formal
sector, accelerating further as these economies
(Thailand and Malaysia in particular) reached full
employment.
There was also a build-up of short-term debt
denominated in foreign currency. While the extent of
this debt was not exceedingly large as a proportion of
GDP, it created potential liquidity problems it was
denominated in foreign currency and it was short term.
For example, when the Bank of Thailand spent most of
its reserves defending the baht, there was little left to
pay off short-term debts were not being rolled over.
The build-up in foreign debt, bank lending, and asset
prices occurred against a backdrop of financial Sector
weakness. The financial sector played a complementary
role in the bull market bubble that developed in
Southeast Asia in 1995 and 1996. Factors in the
financial sector which contributed to the severity the
Asian crisis include the following:
INADEQUATE FUND MANAGEMENT SYSTEM
The financial sectors in these countries were unable to
efficiently handle and disburse the massive inflows of
foreign funds, which allowed them to invest as much as
40-50 percent of GDP when economic growth was in
excess of 8 percent per annum. More than US$400
billion was invested from overseas sources during the
first half of the 1990s. Stock market values also rose
rapidly, and a property boom ensued. This was
unsustainable and inconsistent with efficient resource
allocation.
INEFFECTIVE STERILIZATION OF CAPITAL
INFLOWS The sterilization mechanism that could
have been used to choke off some of the excess
demand generated by the influx of capital was
constrained by thin markets for government securities
and a fixed exchange rate. In such a situation, the
greater the level of sterilization undertaken, the greater
the tendency for the spread between domestic and
offshore interest rates to increase. This simply provided
an even larger inducement for capital inflows.
RESTRICTIONS ON FOREIGN BANKS’
ENTRY Another factor that aggravated these
problems was the restriction on the entry of foreign
banks and financial institutions. Apart from Hong Kong
and, to a lesser extent, Singapore, East Asian countries
do not encourage the entry of foreign firms providing
financial services, compared with other countries at
similar levels of development. They are also more
highly regulated. Consequently, the financial sectors
were less “internationalized” in terms of competition
from financial service providers based in other
countries. In this respect, the financial sectors in these
countries were in marked contrast to the traded goods
sector and capital movements that are highly
internationalized in all the East Asian countries. This
segmentation lowered the diversification of financial
institutions in these countries, and thereby increased
the risk of bank failure. At the same time, internal
liberalization allowed domestic banks to enter new
markets where returns were higher but where risks
were also higher. Offshore banking was one area where
lending boomed in 1995 and 1996, particularly in
Thailand. The returns on borrowing overseas at low
interest rates and relending to local businesses at much
higher rates was lucrative, but tended to ignore the
exchange-rate risk. Furthermore, there might have
been an implicit understanding that a bankrupt bank
would be bailed out by the government. This created a
moral hazard problem and contributed to an even
higher level of risk taking. (See Box. 4.1 for a further
discussion on moral hazard.)
NONPERFORMING LOANS As the economies
overheated in 1995 and 1996, banks made many risky
loans. Supervision and regulation of the financial
systems in these countries were inadequate. Unsound
projects were approved, uncollateralized loans were
made, offshore dollar borrowing, which were un
hedged, ballooned-taking advantage of low interest
rates in the United States. Loans were made to friends,
other corporate managers, and relatives. Evaluation of
the credentials of borrowers became slack, and banks
controlled or owned by the government often provided
loans to ailing or targeted industries. There was a
failure of fiduciary responsibility and a breakdown in
responsibility to show a profit to stockholders. Lending
criteria and capital backing were inadequate and
prudential supervision did not contain the spread of
risky loans. In Malaysia, the Philippines, Singapore, and
Thailand, commercial banks could engage in
underwriting stockbroking and fund management. In all
the East Asian countries except Indonesia and Korea,
banks are allowed to hold equity in non-financial and
financial institutions, subject to some percentage
limitations.
Despite the pervasive problems in the region, the
weaknesses in the financial systems of most of these
countries were, however, not particularly glaring even
up to the end of 1996, The Bank for International
Settlements figures (Table 4.3) show that although high
in comparison with the industrial countries, the share
of nonperforming loans (NPLs) in the Asian countries
was relatively lower in 1995 and 1996 when compared
with the crisis years of the 1980s. While many risky
loans were extended, it was the currency devaluations
that exposed these weak balance sheets. The problems
had more to do with the structure of dollar-
denominated debts and the devaluation that,
combined with poor project selection, created the large
numbers of bankruptcies. This was because many
customers of banks and other financial institutions
used stocks as collateral to borrow offshore at cheap
rates. These customers were unable to repay loans
when both markets collapsed. Furthermore, the
number of bad loans increased as export growth
slowed and as the pyramid of credit to fund real estate
and stock market speculation collapsed.
Fifty-eight financial institutions were closed in Thailand.
Sixteen banks were closed in Indonesia and depositors
withdrew about US$4 billion, according to newspaper
reports. The health of the financial systems in the other
Asian countries has also been questioned. In Malaysia
and the Philippines, no bankruptcies were reported,
but the strain of the currency devaluation and falling
stock prices resulted in slower growth. In Korea, the
financial crisis was reflected in the bankruptcy of a
number of large conglomerates (chaebols), while in
Japan, a large, top-twenty bank, a smaller bank, and
two stockbrokers were declared bankrupt. The
International Monetary Fund (IMF) extended bailout
packages to Korea, Thailand, and Indonesia. The Asian
countries also developed a scheme to pool assets to
help countries in need through the IMF.
HIGH COSTS OF FINANCIAL SERVICES
Crosscountry empirical evidence compiled by the World
Bank suggests that the limited internationalization of
the financial sector also led to higher costs of financial
services (higher interest margins and lending rates) to
borrowers and slower institutional development.
Nevertheless, it was the combination of devaluation
and stock market collapse that exposed the financial
sector to severe balance sheet problems. This was
because many firms had made un hedged borrowing
from the cheaper offshore dollar market (see above).
Furthermore, loans were often made with shares as
collateral.
BALANCE SHEETS The extent of balance-sheet
troubles is difficult to measure without careful
countryby-country analysis. As the crisis and post crisis
period evolved, the evidence suggests that balance
sheets have been helped considerably by the recovery
in demand and the resumption of economic growth in
1999, 2000, and 2001.
2. External Sector Difficulties
A snapshot of external sector developments in the
years preceding the crisis can be seen in Table 4.4.
External sector difficulties in the Asian countries were
said to have been behind the outbreak of the financial
crisis in 1997. They include the following:
RAPID GROWTH IN CURRENT-ACCOUNT
DEFICITS As the boom of the early 1990s progressed,
current-account deficits also grew as offshore
borrowing increased. While exports were growing
rapidly, these current account deficits were viewed as a
positive sign that growth-enhancing and capacity
expanding investments were taking place. During this
phase of rapid growth, current-account deficits of Up to
5 percent of GDP were thought to be easily sustainable,
according to conventional wisdom. Even the more
conservative IMF and the World Bank did not have any
qualms about deficits of 3 percent of GDP. By 1995 and
1996, only the current account of Thailand was in the
dangerous zone of nearly 3 percent of GDP (see Table
4.4). However, Malaysia, the Philippines, and Korea
were all flirting with a 5 percent currentaccount deficit
by 1996, and this loomed large as merchandise export
growth started to soften. On the other hand, Singapore
and Taiwan had very large current surpluses and
seemed immune from any financial turbulence that
might arise in other economies in the region.
OVERVALUED EXCHANGE RATES Prior to the
crisis, the exchange rates for most Asian currencies
were loosely tied to the US dollar. Although ostensibly
tied to a basket of currencies, the Thai baht was pegged
to an exchange rate of 25 baht per US dollar and varied
within a very narrow range. The Philippine peso moved
more but not beyond a band of 25-27 pesos per US
dollar. The Indonesian rupiah, on the other hand,
devalued very slowly and deliberately against the US
dollar over time. This devaluation was so steady and
predictable that it was, in effect, a moving peg against
the US dollar. The Malaysian ringgit fluctuated
somewhat more than the other three currencies,
appreciating against the US dollar during part of the
period, as did the Singapore dollar, but more strongly.
The Korean won and New Taiwan dollar were tied to
the US dollar but they also appreciated somewhat
during 1995 and 1996, while the Hong Kong dollar was
tightly pegged to the US dollar.
Since most currencies were tied loosely to the US
dollar, they followed it down in the first half of the
1990s and then rose with it in the following three years.
The first column in Table 4.4 shows the real effective
exchange-rate overvaluation in June 1997 (when
Thailand devalued) to the average exchange rate for
the decade between June 1987 and May 1997. The
overvaluations varied from 4.2 percent for Indonesia to
22 percent for Hong Kong, which remained on a fixed
parity with the U.S. dollar. In Korea and Taiwan, there
was some undervaluation.
These calculations are meant to be suggestive. Other
estimation methods may yield different results,
depending on the base period and the estimation
methodology. Nevertheless, the evidence does suggest
that there was some overvaluation of the currencies in
the region at the time of the crisis, compared with
historical averages. Furthermore, early warning
estimates using historical data for Asia and other
regions suggest that the real effective exchange rate is
one of the best indicators of an impending currency
devaluation. (Dowling and Zhuang, 2002; Athukorala
and Warr, 2002; and Goldstein, 1998.)
THE COLLAPSE IN EXPORTS In 1996, export-
growth performance fell substantially, particularly from
1995 when exports had been performing spectacularly
(see the last two columns in Table 4.4). It has been
widely speculated that China played an important role
in this: China had devalued its currency by about 25
percent a year or so earlier and had become quite
competitive in a number of markets where the
Southeast Asian economies had a strong presence.
However, this devaluation was the result of a
consolidation of the dual exchange-rate system, and
most trade had been taking place at a lower rate for
several years. Thus, the Chinese currency devaluation
was probably not such an important factor in explaining
the export slowdown in 1996. This inference is
supported by the work of Fernald, Edison, and Loungani
(1999).
Rising wages have been suggested as another possible
cause of the export collapse and it is true that wage
increases were eroding some of the competitiveness in
labor-intensive manufacturing industries in Thailand
and Malaysia. Another and possibly stronger factor was
the decline of activity in the computer-chip market. The
bottom had fallen out of the computer-Chip and
computer-peripheral markets in the industrial
countries. These markets were very important for
Malaysia and to a lesser extent, for Thailand and the
Philippines. Finally, the exchangerate appreciation also
contributed to a loss in export competitiveness. In any
event, as is evident from Table 4.4, the decline in
export growth from 1995 appeared to have been quite
dramatic.
How bad was the export collapse? If we were looking at
another group of developing countries’ exports without
reference to their 1995 performance, the export
performance of 1996 was probably not that bad.
Exports from Indonesia and the Philippines grew at
nearly 10 percent and more than 18 percent
respectively. In the newly industrialized economies
(NIEs) and Malaysia, export growth was down to single
digits (4 to 8 percent). Only in Thailand was export
growth stagnant. Considering that world trade growth
in a good year averages 4 to 6 percent, these export
figures are not surprisingly low if compared with other
developing countries. Furthermore, the 1996 collapse
in exports was still very mild in comparison with
previous low export-growth performances. In 1985, for
example, export growth was negative in all the major
countries of the Association of Southeast Asian Nations
(ASEAN), and less than 1 percent in Taiwan. On the
other hand, the perception that export growth had
collapsed was an important factor in coloring
perceptions about the strength of the Asian economies
and their abilities to repay their external debts.
In summary, a combination of external factors and a
domestic economic boom that had gotten out of
control set the stage for the attack on the Thai baht in
June 1997. Taken alone, any one of these factors would
not have been too worrisome. Taken together, they set
the stage for a nascent crisis. The size and extent of the
crisis as it evolved took nearly everyone by surprise.
This was because of the strength of the contagion
effects, which will be discussed in the following section.
3. Contagion, Globalization, and
Financial Integration
To get some idea of what happened during the Asian
financial crisis, consider the reversal of capital inflows
and bank credit between 1996 and 1997. There was an
enormous reversal of net private capital flows to the
five crisis economies of Indonesia, Malaysia, Korea, the
Philippines, and Thailand between 1996 and 1997, from
a US$97 billion inflow in 1996 to a US$12 billion
outflow in 1997. This US$109 billion reversal was about
10 percent of the pre-shock GDP of these five
economies. On the other hand, the reversal in bank
credit was from an increase of US$56 billion in 1995 to
a decrease of US$27 billion in 1996. Together, these
two shifts in liquidity accounted for nearly 20 percent
of GDP (Shirazi, 1998). It was no wonder that these
economies suffered a severe economic slowdown.
Several other factors have been suggested, including a
slowdown in growth in Europe and a currency
appreciation when the US dollar strengthened. Neither
of these was particularly critical, however. The
developing Asian countries’ trade with Europe was
limited and this downward trend was more than offset
by a strong growth in trade with the United States.
Nevertheless, there were certainly other critical world
trends that influenced events as the crisis unfolded.
They were mainly related to the interaction between
two relatively new phenomena: globalization and
international capital mobility. Globalization linked the
East Asian markets for goods and assets much more
closely to the markets of other countries. This linkage
resulted from the liberalization of trade in goods and
capital in the East Asian countries, which increased the
size of the tradable goods sector as measured by the
trade ratio, and the ratio of exports plus imports of
goods to GDP. These changes also increased the
exposure of the economies of the region to shocks
originating in international trade.
POST-CRISIS EXPERIENCE
The World Economy
Commentators from international institutions were
initially quick to discount the impact of the current
crisis on the world economy. However, weaknesses in
Korea and Japan surfaced toward the end of1997 and
these tended to have wider implications. However,
when all was said and done, the Organization for
Economic Cooperation and Development (OECD)
countries, with the exception of Japan and Korea, were
not appreciably affected by the crisis. World output
growth in 1998 did fall, but this was primarily the result
of a slowdown in the growth of the US economy Asia as
a whole, including India and China, which both grew
rapidly, registered growth of between 1 and 2 percent
(Asian Development Bank, 2002b). This was much
lower than the 1997 figure, but it did not drag world
growth down too much. More importantly, it did not
precipitate into a worldwide recession. In 2001, the US
economy suffered a short and shallow recession from
which it recovered only slowly in 2002. This reduced
the demand for US imports and probably also slowed
the growth of the Asian economies as they continued
to recover from the 1997 financial crisis. However, as
the United States and other industrial countries
recovered, there was a salutary impact on growth in
the
Asian economies.
Economic Growth
The overall economic growth in the Asian economies
did not immediately reflect events in the financial
sector and in foreign exchange markets. However, 1998
was a bad year for most countries in the Asian region.
Growth was negative in all the five crisis countries, as
well as Hong Kong. Singapore grew by only 0.1 percent,
compared with 8.5 percent growth in 1997. There was,
however, a strong recovery in 1999, which
strengthened in 2000, particularly in East Asia and
Malaysia (see Table 4.5). The recovery of Korea was
particularly significant. Nevertheless, the slowdown in
growth in the United States and other industrial
countries had a negative impact on economic growth in
East and Southeast Asia in 2002. The effect of this
slowdown in the industrial countries was particularly
severe in those countries that had strong trade linkages
with the United States, and where international trade
in electronics was high. This group of countries included
Malaysia, Singapore, and Taiwan, among others.
During the following five years, the global economy
recovered and so did the Asian economies. Between
2002 and 2007, economic growth in the Asian region
accelerated, led by India and China. Living standards
rose and poverty fell (see Table 4.5). Domestic demand
and foreign trade were both important factors in
the resumption of growth.
EXCHANGE RATES Exchange rates have
strengthened from their lows in the first part of 1998
(see Figure 4.1). This extends to all currencies, even the
Indonesian rupiah, the most adversely affected
currency. Depreciation vis-a-vis pre-crisis levels was
between 15 and 30 percent as of July 2002. In
subsequent years, between 2003 and 2007, there was
an appreciation of some Asian currencies, particularly
in 2006 and 2007-about 6 percent for China relative to
2005, 9 percent for Korea, 12 percent for Thailand, and
16 percent for the Philippines. Other currencies
depreciated slightly.
EQUITY PRICES Stock prices also rebounded. In
Korea, they had risen above pre-crisis levels by the
middle of 1999. Stock markets elsewhere in Asia also
rebounded as funds from the rest of the world started
to return. This served to reinforce the optimistic feeling
that was spreading throughout the region (see Table
4.6).
From 2002 to 2007, stock markets in Asia generally
increased, often dramatically. The Bombay stock
market in India increased ninefold, the Jakarta index
around sixfold, Korea fourfold, the Shanghai and Hong
Kong indices tripled, and the Taiwan stock market index
more than doubled. Since the beginning of 2008,
however, growth in the industrial countries has
faltered, and all the Asian markets have weakened. The
extent of this weakness is displayed in Table 4.7. The
fall in stock market values since the beginning of 2008
is largely due to weakness in the global markets,
particularly for Asian exports as a result of a recession
in the industrialized countries. Consequently, this is
expected to result in much slower growth throughout
the Asian region in 2009.
withdrawal of funds by short-term lenders, a collapse in
currency exchange rates, and bankruptcies caused by
the burden of un hedged foreign debt.
Indeed evidence suggests that currency depreciation
inflicted much less damage on firms than the rise in
interest rates and cut-backs in domestic credit lines
because many firms with large foreign indebtedness
were export-oriented. If credit lines had been
maintained greater competitiveness and growing
export revenues would have provided a cushion against
rising liabilities in domestic currency as a result of
depreciation. . . . In a sense, orthodox policies
succeeded in stabilizing exchange rates not by restoring
confidence through high interest rates as intended but
by creating a deep recession. . . . (UNCTAD, 2000, p.
53).
The report goes on to say that the recession may have
been avoided if a temporary debt standstill (their words
for moratorium) had been put into effect and
borrowers and lenders brought together to reschedule
short-term debt. This would have avoided high interest
rates and the subsequent reduction in domestic lending
and the contraction in aggregate demand.
Furthermore, the Malaysian and Chinese experience of
fixing the nominal exchange rate did not necessarily
lead to currency appreciation since there were effective
controls over capital flows.
Recovery came through a revival of domestic demand
supported by exports and a restoration of investor
confidence. Softer budget deficits and lower interest
rates also underpinned the recovery. The slowdown in
the growth of the industrial countries in 2001 initially
served to moderate the recovery in Asia. However,
sustained growth in these countries later helped to
reinforce the subsequent recovery of Asia in 2002 until
2007. In addition, as noted below, there was a very
strong turnaround in the current account balances (see
Table 4.7). Export performance also recovered
significantly.

A dramatic turnaround in the external balance was

RESTRUCTURING Many weaker firms throughout
experienced by many countries, especially the trigger
the region went out of business during the Asian
economies (see Table 4.8), which saw huge surpluses,
financial crisis. Those that survived were Operating
compared with the large deficits in 1996, as can be
more efficiently. Banks started to become more
seen in Table 4.4.
stringent about lending and took greater care to
evaluate borrowers. Thailand is a case in point. There
was also more transparency and ongoing attempts to
deal with corruption and shady business practices. Even
as the Asian economies recovered, they put in more
efforts to avoid the potential bubble that had resulted
in the previous crisis.

Economic Recovery

As we have seen above, the downturn in most

economies was not caused by a dramatic fall in exports.
Rather, it was a result of a combination of the

These surpluses have grown even more in the past five
years, particularly in Malaysia, China: Hong Kong, and
Singapore. The primary reason for the quick turnaround
in the external balance lies in the collapse in imports in
the early years of the recovery, while exports remained
relatively strong. This turnaround in the net export
balance had a significant stimulating effect on overall
GDP and GDP growth (with net exports increasing from
a large negative to a large positive figure.) This
reinforces the conclusion drawn earlier that the
recession in Asia was primarily a failure of domestic
demand. The collapse of domestic income resulted in a
commensurate fall in imports, which was compounded
by the rise in the cost of imports following the currency
devaluation. In countries that were less affected by the
recession (China, Taiwan, and Singapore to some
extent), the change in the current account was much
less dramatic, although there were subsequent further
improvements in the current account and trade
balance in all the countries in the region.
All the crisis economies have made a recovery,
although there are still difficulties in resolving
nonperforming loans and weaknesses in the financial
sectors of several crisis economies, particularly
Thailand and Indonesia, which retarded further
recovery in 2003 and 2004. However, by 2007, all the
trigger economies were in good financial shape.
Countries suffering from a high level of nonperforming
loans followed different strategies. These strategies
and the structure of banking in Asia are discussed more
extensively in Chapter 7. However, it can be said briefly
here that in Thailand, where a market-based approach
to bad loans was adopted initially, recovery rates were
slow and progress limited. Thailand subsequently
adopted a government led approach, as did the other
crisis countries-Indonesia, Korea, and Malaysia, which
saw more satisfactory recovery rates. The Philippines
felt there was no need for a restructuring agency. In
Korea, the government has been quite proactive in
supplying fresh capital and nationalizing banks in
difficulty. This initiative proved quite successful and
Korea has now recovered substantial strength in its
financial sector.
Social Impact of the Economic Crisis
The crisis put extreme pressure on many sectors of the
economies of the five crisis countries. The credit crunch
made banks reluctant to lend and firms were starved of
working capital; currency depreciation made it difficult
for firms to service external debt; inflation accelerated
and purchasing power fell as the price of imports
increased and government revenues came under strain
when the tax base contracted and incomes fell. The
price of providing public services also increased, while
the ability to undertake compensatory spending was
constrained by the crisis itself. As a result, there was a
fall in output, an increase in unemployment, and the
incidence of poverty.
As the crisis deepened and economic conditions
worsened, there was an increase in reverse migration
as urban residents moved back to the province.
Fortunately, the agricultural sectors of the affected
countries were not as hard hit as the urban sectors, and
the rural areas were able to absorb these returning
workers without much trouble. At least, they could
provide subsistence levels of food and housing.
The formal rate of unemployment increased
dramatically in all four of the crisis countries (excluding
the Philippines), as reflected in the estimates made by
ESCAP, shown in Table 4.14.
These figures do not tell the entire story as the
unemployment rate is compiled mostly from urban
employment figures, which exclude the large rural
sector where the impact of the crisis was less dramatic.
Moreover, self-employment opportunities sometimes
provided work for those laid off. However, wages also
fell for those already employed.
Estimates of poverty reported by ESCAP show increases
from 6.8 percent to 8 percent in Malaysia between
1997 and 1998, while in Thailand, the rate rose from
11.4 percent in 1997 to 15.3 percent in 1998. The
estimate of poverty increasing from 11 percent to 40
percent in Indonesia seems improbable.
Budget cuts and reduced incomes had an adverse
effect on expenditures on health and education during
the crisis. Health budgets were cut by more than 5
percent in Thailand and 4 percent in Indonesia, and
consumers also shifted away from expensive health
care services to lower quality and cheaper services. The
impact on infant mortality and malnutrition has not
been estimated but was probably quite substantial.
There was also a higher incidence of mental health
problems as unemployment grew, and tighter
household budgets increased mental stress, family
violence, and the crime rate.
The rates of school dropouts rose as many families
found it difficult to afford even the minimal costs of
sending their children to school. Instead, they were
either put to work in the informal sector or forced to
stay at home. In Indonesia, as many as 25 percent of
children dropped out of school. The highest rate being
for high school students whose school fees were more
unaffordable (Knowles, Pernia, and Racelis, 1999).
There was greater discrimination against girls, who
were often forced to stay at home while limited
resources were used to educate the boys in the family.
A detailed and in depth study of the impact of the crisis
by the Asian Development Bank (Knowles, Pernia, and
Racelis, 1999) suggests that the impact of the crisis
varied significantly from economy to economy and one
should be careful about making blanket judgments. For
example, they found no consistent evidence that
children had been taken out of schools in large
numbers as a result of the crisis, nor was there any
evidence of significant adverse health effects on
children. At the same time, there was a sharp decline in
real per-capita income between 1997 and 1998-20
percent in Korea, 12 percent in the Philippines, and by
about 24 percent in Indonesia.
They found that households used a number of coping
mechanisms to deal with the crisis. Some of them
helped to smooth consumption and made adjustments
to minimize the impact by working longer hours,
delaying purchases of durable goods, and substituting
cheaper foods. Others involved postponing or shifting
the impact of the crisis to the future, by borrowing or
taking children Out of school. Since the income
constraint was more binding on the poor and
institutionalized populations, such as the disabled, the
elderly and children in orphanages, these methods
were used more often and imply intergenerational loss
of welfare as a result of lost schooling. Their study
concluded that certain disadvantaged groups, such as
the poor, women, children, and the elderly were
particularly hard hit by the crisis.
Their study also suggests that better targeting
mechanisms have to be developed together with better
social safety nets. Monitoring systems also need to be
set up to keep track of target populations in situations
of crisis. This includes poverty monitoring together with
the delivery of public services.
As the Asian economies recovered from the crisis, the
unemployment rate fell and growth accelerated.
Significant progress was also made in reducing poverty
further. Between 1998 and 2002, the percentage of
people below the poverty line fell from 13.3 percent to
11.5 percent in the Philippines, from 5.2 percent to 2.4
percent in Thailand, and from 15.4 percent to 12.7
percent in China (Dowling, 2007). Poverty rates also fell
in other Asian economies (Dowling, 2008).
LESSONS AND PROSPECTS FOR THE FUTURE
An Agenda for Reform
Based on the reform agenda prescribed by
international banks and aid agencies after the crisis, we
list the following items that could be helpful in
speeding up reform in the crisis-affected countries of
Asia. This list makes much sense and can be easily
extended, with some modifications, to global structural
reform.
DEBT RESTRUCTURING Great emphasis is placed
on an orderly restructuring of debt. This will be more
difficult than in the Latin American case because there
are more lenders and borrowers, and the private sector
is heavily involved. However, the process has already
started and will be made easier as balance sheets
improve in 2000 and beyond.
PRIVATE-SECTOR CREDIT LINES Given the
limited resources of the IMF and the conceptual
difficulties with the notion of an international lender of
last resort, it may be useful for governments to
establish credit lines with the private sector. Argentina
entered into such arrangements with foreign banks
before the Mexican crisis, and they did supply credit to
the country. These facilities could be strengthened by
multilateral guarantees from the World Bank or the
IMF.
REFORM EXCHANGE-RATE REGIMES Many of
the problems faced by developing countries in Asia
were the result of “hot” money outflows during the
crisis that resulted in abrupt currency devaluations.
Many businesses and banks borrowed in foreign
currencies and held large un hedged positions. As
currencies devalued, they had great difficulty in
meeting their foreign obligations. Some went bankrupt
governments also lost substantial reserves in trying to
defend fixed exchange rates.
A pure, flexible floating exchange rate allows
continuous adjustment to accommodate changes in
relative price movements or commodity markets.
Those who advocate such a system argue that a flexible
exchange rate provides a clear signal of the effects of
government policies. In any event, whether a peg
against a basket or a free float is adopted, the new
exchange-rate regimes in this region will have much
greater flexibility than they had before and this will
help to prevent repeat episodes of macroeconomic
disequilibrium. By moving to a flexible exchange-rate
regime, the chances of such defaults occurring would
be minimized since the costs of not hedging would be
more apparent. Furthermore, the exchange rate would
automatically move in response to capital inflows and
outflows, thus reducing the chances of an inflationary
bubble arising.
CAPITAL ACCOUNT REFORM The regulation of
short-term capital movements, such as through the
imposition of taxes, can be considered. The experience
of Chile is useful to study in this regard. It is also
important to carefully consider further capital market
deregulation. This is particularly true when domestic
capital markets are underdeveloped or where it is
difficult to control excessive risk-taking by domestic
banks and businesses.
INTERNATIONAL PORTFOLIO
CONTROLS UNCTAD also suggests in its report that
controls on international portfolio investment at the
source of the lending should be explored. This would be
in addition to measures taken by developing country
governments to impose capital controls. These controls
would involve monitoring and supervision of
international financial firms (banks, insurance
companies, pension funds, financial conglomerates).
Another proposal is to focus on international
banklending practices by putting a ceiling on lending
which would be insured through a new sister institution
to the IMF, called the International Credit Insurance
Corporation (ICIC).
ESTABLISH MINIMUM INTERNATIONAL
STANDARDS OF FINANCIAL PRACTICE Auditing
and accounting practices still vary considerably across
countries. This makes it difficult for lenders to gauge
the financial conditions of borrowing banks and
business firms. Differences in corporate governance
practices, investor protection, and insider trading also
reduce transparency and increase risk. The
establishment of minimum international standards
would create a floor of credibility which would also
help to prevent national problems from spilling over
into international markets.
INFORMATION AND TRANSPARENCY The Asian
crisis has reinforced the need to pay greater attention
to constructing uniform standards for accounting and
financial reporting. UNCTAD does not believe that the
lack of more general macroeconomic information, such
as that supplied through the IMF’s Special Data
Dissemination Standard (SDDS) system, contributed to
the crisis.
GLOBAL SURVEILLANCE How can the existing
surveillance mechanism be improved to reduce the
probability of future crises? In the Asian crisis and also
in the Mexican crisis, the IMF warned Mexico and
Thailand regarding its external debt policies. Yet the
advice went unheeded both by Thailand and the
international financial community. UNCTAD suggests
that the emphasis of IMF policies must shift from
domestic policies to the possible impact of external
policies of the major industrial countries on developing
countries and on the surveillance mechanisms that
address these issues. They also ask whether the IMF
surveillance should be extended to financial regulation
and standards for financial reporting (see below for
more on this.)
REFORM OF FINANCIAL MARKETS Another set
of necessary reforms comes under the heading of
financial market regulation. The details will depend
upon the existing system of regulations in individual
countries.
GREATER COMPETITION Subsequent to the crisis
in Latin America, foreign banks flocked to the region,
lured by bank privatization and the relaxation of
ownership rules. They brought fresh capital and
stateof-the-art technology. More than a fifth of
Mexico’s banking system is now in foreign hands. Asia
could learn from this experience. It is still highly
protected and restrictions have inhibited the
development of new services and narrowed the scope
for diversification (only Malaysia has greater than 7
percent of total assets owned by foreign banks). The
arguments in favor of foreign participation in this
sector are essentially the same as those that have
proved very successful in opening up the goods sectors
in these countries to international trade and greater
competition. However, in arguing for greater
competition, we must remember that each of the crises
that we have looked at came after the liberalization of
banking regulations, which resulted in a move into
more risky assets. Competition has to be tempered
with strengthened prudential regulations. .
CONSOLIDATION in Latin America, governments moved
quickly to close the worst-performing banks. At the
beginning of the crisis, the Asian governments were
loath to close banks for good, and the number of
mergers was also small.
SUPERVISION AND REGULATION New
regulations should follow principles, such as those laid
down by the Basle Committee on Banking Supervision
(1997). Countries can also benefit from studying new
developments in other developing countries, such as
Argentina and Chile In Chile, the central bank regularly
visits banks and classifies them based on the quality of
their loan portfolios and then publishes the results. In
Argentina, regulation is shared between the state and
the market. Banks are required to issue bonds linked to
the value of their deposits. The price of the bonds
indicates the strength of the bank in the eyes of the
market. While new methods of regulation such as these
would have to be reviewed, a different pattern of
regulation with tighter controls in some areas and
weaker controls in others is required, rather than a
blanket deregulation.
ACCOUNTING AND DISCLOSURE Tougher
accounting and disclosure rules will help to expose
weaknesses before they can fester. Greater
transparency and higher standards are needed,
particularly where the rules are woefully deficient. In
Korea, for example, banks do not have to disclose, let
alone make provision for all of their suspect loans.
STOCK MARKETS A major reform would be the
introduction and development of the derivatives
market, particularly in Thailand, Malaysia, and
Indonesia, especially those permitting better hedging of
equities exposures. Access by foreign investors should
be significantly liberalized (elimination of B shares
where they still exist) and the imposition of price limits
to trade, such as those adopted by the New York Stock
Exchange, should be reviewed.
TRADE POLICIES Further reforms of trade policies
are desirable. However, Thailand and Malaysia have
raised tariff rates after the crisis and this could be
harmful and unnecessary, particularly given the large
exchange-rate devaluations. Countries in Asia have an
exceptional record of unilateral reductions in tariff and
other border restrictions on trade in goods. Trade
liberalization should be continued. In the case of
Indonesia, the IMF package requires them to remove
the international trading monopolies for some
commodities, but others remain. These are particularly
objectionable because they combine the monopoly
powers of single traders (as with the statutory
monopolies in Australia) with the transfer of these
valuable implicit property rights to the individuals who
were granted the monopolies. These countries have
been much less active in reducing restrictions on
service trade in general. The current WTO negotiations
on an Agreement on Financial Services provide an
opportunity for the developing countries to join the
industrialized countries in liberalizing trade in these
services.
FOREIGN DIRECT INVESTMENT Another critical
area is FDI incentives. These incentives were a factor in
the rapid expansion of FDI and capital formation, as a
result of which the East Asian developments in other
developing countries, such as Argentina and Chile In
Chile, the central bank regularly visits banks and
classifies them based on the quality of their loan
portfolios and then publishes the results. In Argentina,
regulation is shared between the state and the market.
Banks are required to issue bonds linked to the value of
their deposits. The price of the bonds indicates the
strength of the bank in the eyes of the market. While
new methods of regulation such as these would have to
be reviewed, a different pattern of regulation with
tighter controls in some areas and weaker controls in
others is required, rather than a blanket deregulation.
HUMAN CAPITAL Finally, more long-term measures
need to be taken to address the shortage of human
capital required to upgrade the productivity capacity in
skilled and knowledge-intensive industries. The pattern
of international trade is shifting more and more toward
these areas. Nearly all of the industries that have
increased their share of international trade in the past
two decades have been in these industries, particularly
computers and electronics. The countries in East Asia
have generally taken advantage of this trend and have
increased their share of manufactured exports in these
industries. However, additional efforts will have to be
made to continue the process of technological transfer
into these industries and to deepen the product mix of
exports. Thailand and Indonesia are particularly at risk
if they fail to address these issues, since they have
noticeable deficiencies in knowledge and
technologyintensive industries.
BETTER UNDERSTANDING OF THE CRISIS
PROCESS The Asian crisis, as many crises before, was
unanticipated. This is how a crisis situation is explained.
Rapid revisions of expectations and herd mentality are
essential components of the anatomy of a crisis. Each
crisis is unique, yet we can learn from an in-depth
analysis of each individual crisis. The Asian crisis had
many of the attributes of a domestic bank run. Careful
analysis by many economists suggests that there were
no dramatic signs that the crisis was imminent. There is
also evidence that the IMF misunderstood the nature
of the crisis and was slow to respond to the
requirement for a different set of policies.
NEW DATA Is there new information that should be
monitored in order to anticipate another crisis of this
type? Furman and Stiglitz (1998) have suggested the
ratio of short-term debt to reserves as a possible
additional indication of potential financial crisis. They
found that the IMF-assisted countries of Korea,
Indonesia, and Thailand all had a ratio greater than
one. They argue that a high ratio shows a lack of
liquidity, and hence, a higher probability of a bank runs.
They also suggest that it signals poor macroeconomic
policies in other areas too. However, some countries do
not fit the mould. Singapore was one of the countries
with a high ratio, higher than any of the IMFassisted
countries, and Malaysia, another problem country, had
a very low ratio.
NEW ANALYSIS None of the models that had been
previously devised by economists to predict potential
crisis were able to do so. Furman and Stiglitz (1998)
suggest that we need to deepen our understanding of
the relationship between financial and real variables in
a globally integrated world. In particular, they stress
the importance of understanding the interrelationships
within the financial sector as well as how it interacts
with the real sector.
By 2008, many of the suggested policy initiatives
outlined above had already been adopted. Growth
rates have accelerated, exchange-rate regimes have
become more flexible, international reserves have
increased, and current-account balances have
improved dramatically. In fact, two countries in each
region (ASEAN-S and East Asia-4) had double-digit
current-account surpluses (see Table 4.15) and the
remaining countries also had current-account
surpluses.
ECON (WEEK 3) LEARNING CONTENT
Introduction:
The main structural development that separates a
modern high-income economy from a traditional
lowincome economy is the rapid development of the
industrial sector. Broadly speaking, in the early stages
of development, the industrial sector comprises
anything that is not agricultural in nature. It includes all
non-agricultural products. This process of
industrialization has been very dramatic in many
developing countries and accounts for much of the
dynamism of the East Asian “miracle” countries and
selected rapidly growing economies in Latin America.
As a matter of interest, large countries are likely to
have a larger share of income generated by the
industrial sector because of economies of scale.
Furthermore, higher income per capita is closely
associated with a higher level of industrialization if we
look at a broad range of developed and z} developing
countries. There are exceptions, such as Australia and
New Zealand, which developed specialization in
minerals and agricultural products respectively. There is
also the case of India, which has a large industrial
sector but which is still quite poor.
In this module, we will review the process of
industrialization generally and in the Asian economies
in particular.
Lesson Proper:
A MODEL OF STRUCTURAL CHANGE
The Jamaican economist and Nobel Prize winner, W.
Arthur Lewis (1954) developed the first two sector
model which attempted to capture the interaction
between a traditional agricultural sector and a modern
industrial sector for a developing economy John Fei and
Gustav Ranis (1964) built upon his work a decade later.
The model they developed is therefore often called the
Lewis-Fei-Ranis (LFR) model. This model has two
sectors which can be defined as traditional and
modern, agricultural and industrial, or rural and urban.
These are rather fuzzy definitions and we can expect
overlaps between different definitions. For example,
there may be traditional characteristics in the informal
sector of the urban economy. Or there may be modern
agricultural processing industries in the countryside.
The essence of the model is to contrast traditional
agricultural methods and rural social organization,
which revolves around family enterprises, with the
modern industrial sector where workers earn Wages
and industrial goods are produced
What are the Features of this Model?
First of all, capital accumulation fuels the development
of the industrial sector. It grows faster as capital
accumulates. There is assumed to be surplus labor in
the rural/agriculture sector. The supply of this labor is
virtually unlimited. Its opportunity cost is virtually zero.
When it is removed from the rural sector, the output of
the sector does not change at all, or very little. This
would occur when there is high population density in
the rural areas and when family farming is widespread.
Family farms do not hire labor (and pay them the value
of their marginal product). They operate on different
principles. Everyone shares in the output, so that
workers are essentially paid the value of their average
product.
By removing excess labor from the traditional sector
and moving it to the industrial sector, the productivity
of labor increases. Furthermore, the productivity of
those remaining in the rural sector also 1mproves since
there is fewer workers-the surplus workers have been
removed.
The LFR model assumes a particular kind of social
organization in the agricultural sector, which is
traditional in nature, and also that the marginal product
of the last workers is zero. There are a few ways we can
test this theory. We can look at the evidence. There
have been sustained movements from the rural to the
urban economy in most developing countries. The
productivity in agriculture has increased in these cases.
It could be because of technology; certainly prima facie
evidence suggests that there is some validity. The mere
fact that lots of workers did migrate and continue to
migrate is also evidence in support of the theory. This
partly reflects the higher productivity of workers using
more capital and therefore a higher wage in the city,
but it also reflects the lower average wage in
agriculture when the land is flooded with labor.
In the LFR (1954, 1964) model, the surplus labor
movement into industry provides a net gain to the
society. If the total output of the agricultural sector
does not fall, then food production is unchanged and
the transferred workers will be fed by the agricultural
sector (without trade), which will also be adding to
output in the industrial sector.
Once the stock of surplus labor is exhausted, the
process of industrial development becomes an
interplay between the two sectors as the wage rate is
driven up in both sectors. Historical experience tells us
that it is important to keep the terms of trade between
these two sectors on an even keel. What do I mean by
this? If the terms of trade move too strongly against the
agricultural sector, they will not be able to buy enough
equipment to fuel technological developments in the
sector. By starving agriculture, industrialists will choke
themselves to death in the long run. If the terms of
trade turn against industry, then industrial investments
will not be profitable and investment will slow.
Introduction of Trade into the LFR Model
When we introduce the possibilities of trade, the model
becomes more complex but the basic features remain.
For sustained growth to continue once the surplus
labor phase has ended, the balanced treatment by the
government in terms of taxes and subsidies has to be
maintained in order for growth to be rapid. The
surpluses from agriculture have to be mobilized to
create investment for the industrial sector. At the same
time, these taxes cannot be so high that they strangle
the rural sector One thing we do know is that export
taxes, or an artificially low exchange rate, are not good
ways to extract the agricultural surplus as these could
have detrimental effects on long-term export-led
growth A food self-sufficiency policy is often followed
when a more satisfactory outcome can be achieved by
trading Nevertheless, many countries still follow food
self-sufficiency policies for political reasons. Farmers
can form a powerful lobby and have been able to
persuade legislators to enact legislation that restricts
trade and provides large subsidies to farmers who are
inefficient on the world market. In Asia, Korea and
Japan heavily subsidize rice farmers, while the
European Community (BC) and the United States also
have large farm subsidy programs.
BACKWARD AND FORWARD LINKAGES
The interaction between the industrial and rural sectors
can be studied using the concept of backward and
forward linkages. If direct backward linkages are strong,
when an industry grows its suppliers also grow. The
extent of this linkage can be measured by subtracting
the purchases from abroad and its own costs from the
value-added generated by the industry itself.
Indirect Backward Linkages
Indirect backward linkages are the secondary effects
which growth in an industry has on its suppliers.
Industries that have strong backward linkages have low
value-added and a large input from local suppliers.
General industries with strong backward linkages
include leather, clothing, textiles, food and beverages,
and paper. The lowest backward linkages are in
agriculture, public utilities, mining, and services.
Laborintensive manufacturing industries have the
highest linkages, while primary industries have the
lowest.
Forward Linkages
Forward linkages tell us how a product is related as an
input into the production of a product at the next
stagetextiles into apparel, for example, or petroleum
into plastics. Forward linkages are a good indication of
the extent to which an economy can upgrade its
industrial base by using its existing expertise and
resource base.
Both backward and forward linkages are determined
from coefficients in input-output tables for individual
economies. They do not tell us much about the
dynamics of the process of industrialization in terms of
causation, but they are useful to better understand the
interrelationships that exist within an economy, and
can serve as a beginning point for analyzing changes in
industrial structure. Analysis of changes in these
linkages can also be helpful in assessing the progress of
an economy in its efforts to industrialize.
The Asian newly industrialized economies (NIEs) and
the countries of Southeast Asia began their
industrialization process with import-substituting
industries but later began to focus on exports in
laborintensive industries, such as leather, clothing, and
textiles. Because of the strong backward linkages these
industries had on agriculture, there was a mutually
reinforcing cycle of growth. At a later stage, these
countries moved into more skill and capitalintensive
industries.
ASPECTS OF INDUSTRIAL DEVELOPMENT
Choice of Technology
As part of the process of industrialization, there will be
a change in the production process as relative prices of
factors Change. In the early stages of industrialization,
countries have limited capital and Plentiful labor. Using
simple production theory, factor proportions are
determined by the relative cost of Capital and labor.
Labor-intensive technologies may be appropriate in a
poor country with plenty of low-skilled and cheap labor
but because of factor market distortions (such as those
created by tax breaks for capital equipment), the choice
of technology may be more capital-intensive.
Economies of Scale
Economies of scale come into play when a country is
exporting, or when production is taking place on a large
scale for the domestic market. This enables companies
to operate at the low point on their cost curves. In very
small countries, it may be difficult to reach a
competitive plant size if production is intended for the
domestic market alone. Similarly, even in larger
countries, some industries may be inefficient-such as
the automobiles industry in most Asian countries and
Australia.
The standard for measuring the efficiency of an
industry is to use the price of imports. Sometimes a
protective tariff is imposed to keep out cheaper foreign
products through infant industry protection.
EFFICIENCY ISSUES Economic Efficiency and Scale of
Production
Which firms are more efficient? Does firm size have a
systematic impact on costs? Given economies of scale,
we might think that the larger the firm, the more
efficient it would be. This is not necessarily the case as
size can introduce inefficiencies. Efficiency depends
upon a number of special factors. It may be that all
firms can be efficient if they have reached a viable size
of production that takes full advantage of economies of
scale. It is true that there are more small firms in
poorer countries but that could just be because of a
lack of capital, or the fact that the market size is
limited. Better transport and communication also make
it possible to have a nationwide production, marketing
and distribution strategy where goods are produced in
the cheapest locations and then shipped all over the
country. In recent years, with the development of
information and computer technology, this strategy has
been extended internationally through the
development of networks for subcontracting and
outsourcing.
Do Protected Industries Become Efficient Over
Time?
Evidence suggests that there are numerous pitfalls to a
strategy of protecting infant industries. These
industries and firms will eventually be forced to
compete in external markets. In order to be
competitive, they should be in an industry where the
country has a comparative advantage or else they will
be inefficient. A comparison of India with Korea throws
up some interesting facts. India protected many of its
domestic industries for a long time, for example,
automobiles, iron and steel, and others. These
industries did not become competitive internationally
and have been a drain on the public purse for many
years. They were inefficient and not competitive. Only
in the 1990s, when regulations on the inflow of foreign
capital were relaxed, was India able to produce a range
of automobiles at reasonable prices through the use of
modern technology. In Korea, subsidies were also
given, but these subsidies were performance
relatedthat is, they were withdrawn if the industry did
not emerge with strong export products after the initial
years of protection. While Korea made many mistakes
in promoting heavy and chemical industries in the
1980s, the country also became one of the fastest
growing countries in the world during the early 1970s
until the early 1990s. It joined the Organization for
Economic Cooperation and Development (OECD) in
1996. A similar story can be told for Taiwan, although
the emphasis there was on the development of
smalland medium-scale industries. These cases and
those of the other NIEs and the economies of Southeast
Asia are explored further in the following section on the
Asian experience.
Are There Advantages to Small-Scale Industrial
Development?
Small-scale enterprises (or small and medium
enterprises-SMEs) are generally more labor-intensive.
Start-up costs are small and entry and exit is easy
because of the small amount of capital needed. They
tend to fail more frequently. Small-scale firms can be
very successful when they concentrate in particular
locations where they can share a skilled labor force
base and where they can produce differentiated
products of high quality. Industries which require craft
occupational skills, such as particular kinds of textiles
and apparel (batik, silk, specialized cottons), and
footwear as well as textiles, are among these.
Smallscale firms depend more on economies of
agglomeration, which are generated by proximity to
firms engaged in similar sectors or in complementary
production. Most small producers need access to
intermediate material inputs and thus prefer to be
close to ports or other transportation facilities. The
case of Taiwan is very interesting. The economy has
grown very rapidly for several decades and it was not
affected much by the Asian financial crisis. Small and
mediumsized firms dominate its industrial structure.
FOREIGN TRADE
Exports are critical in explaining productivity gains in
the Asian economies. Internal competition does not
seem to be sufficient to bring about high rates of
productivity increase. For example, in large countries
with low industrial concentration ratios, efficiency rates
are still low. The textile sectors in India and the
Philippines are good examples. Why? Perhaps it is
because of licensing arrangements, or a lack of
technological transfer as a result of taxes on imports.
There is evidence that better internal allocation of
resources can add greatly to economic efficiency. Firms
financed by foreign direct investment (FDI) are, other
things being equal, more efficient than their domestic
counterparts! There may be many reasons for this but
probably the most important is the need to be
competitive internationally. Strategies for international
trade are important for studying the growth experience
of developing countries.
OTHER TRANSITION ISSUES
Indonesia has not been able to make the transition to
higher value-added products that are in demand in the
OECD countries as quickly and as effectively as its
neighbors in Southeast Asia. There are several reasons
for this. First, Indonesia still has a large oil and natural
gas sector and some of its resources are devoted to
maintaining and expanding this sector. Secondly, it had
a late start in the industrialization process in the early
19803, and Malaysia, Thailand, and the Philippines had
more than a decade’s lead in industrializing. Thirdly, it
has a labor force that lacks education and training to
implement technology in these new industries on a
wide scale. Fourthly, even after it began industrializing
engineers, who thought they could leapfrog to higher
levels of technology, dominated much of its
development thinking. Such a strategy was not
successful and it further held back the transition to
labor-intensive industries that are the country’s
comparative advantage.
To some extent, Thailand also suffers from a lack of
skilled manpower. The educational system is
particularly weak in providing technicians with strong
secondary school training. The other countries 0f
Southeast Asia, such as the Philippines and Malaysia,
are better positioned to take advantage of the
°PP0rtunities for upgrading their industrial capacity.
Their labor forces are better trained and are more
familiar with English.
THE ASIAN EXPERIENCE WITH
INDUSTRIALIZATION
The first thing to note about the Asian industrialization
and growth experience is that it was unprecedented in
economic history. From the mid-1960s to the late
1990s, the growth rate of the East Asian economies of
Hong Kong, Korea, and Taiwan, together with
Singapore in Southeast Asia-sometimes called the Asian
“tigers,” or the newly industrialized economies (N IEs)-
grew at a faster rate than any other economy or group
of economies had in history (World Bank, 1998; and
Quibria, 2002). Per capita incomes increased by about 7
percent per year, so that income doubled every ten
years at the end of thirty years, incomes per capita had
increased fourfold
Furthermore, during the same period the industrial
sector’s share of gross domestic product (GDP) in these
countries also increased sharply. In the case of Korea,
the share went from about 24 percent of GDP in 1970
to nearly 38 percent in 1980 and even higher in 1990.
This implies an even more spectacular growth rate for
the industrial sector than for the overall economy. In
Taiwan, Singapore, and Hong Kong, the increase in the
share of industry was more modest but it also saw a
more rapid g1owth in the industrial sector than in the
economy as a whole. How were these economies able
to sustain such a breakneck pace of growth of industry
for such a prolonged period? Economic historians point
to a period of growth in the Japanese economy from
the Meiji Restoration to the middle of the twentieth
century as a comparable period of rapid growth. In fact,
it was only about half as fast as the growth of the Asian
“tigers”.
The Electronics Sector
In order to examine the structural transformation in the
industrial sectors of the NIEs and to look more closely
at the role of technology, it is useful to focus on the
electronics industry. This broad industrial category had
become the most important export of the NIEs, as well
as the countries of Southeast Asia by the end of the
1990s. Hobday (1995) suggests that the changes in the
electronics industry ‘can be described by a stylized S
curve representing the size of exports, as well as the
technological frontier and research and development
(R&D) expenditures. In the 1950s and 1960s, the
industry grew slowly as firms became familiar with
elementary technology, including simple assembly and
the assessment and selection of production techniques.
In the 1970s, the rate of export growth accelerated and
the inflow of technology from foreign firms also
increased; Reverse engineering was undertaken and
the adaptation of technology was further enhanced.
Eventually the industry moved toward indigenous
design for manufacturing and applied R&D in the
1990s.
Different Patterns of Technological Transfer
The methods varied from economy to economy.
Singapore and Hong Kong were open to foreign direct
investment and worked hard to attract it by offering
full ownership, low taxes, and access to modern
infrastructure and a well-educated workforce.
Singapore adopted a hands-on industrial policy and
while it did not necessarily try to influence which
industries located in Singapore, it played a strong role
in helping to train the workforce and to provide
industrial infrastructure. Hong Kong took a more hands-
off attitude, though it did have a very liberal and open
economy. Most of the investment that came into these
two countries was via the foreign investment of
transnational enterprises (TNCs); Korea and Taiwan
were less open in the manner in which they obtained
foreign technology. They did not encourage foreign
firms to set up operations. Rather, they adopted
arrangements where local subsidiaries produced for the
foreign companies, either to their exact specifications
(original equipment manufacturingOEM) or according
to their own designs or a combination of foreign and
local designs (own design manufacturing-ODM). They
did not generally form joint ventures although they
sometimes used licensing arrangements. Later in the
industrialization process, they also made 'Some
overseas acquisitions and formed strategic partnerships
with overseas companies to acquire technology. Even
though there were distinct differences in the degree of
government intervention and openness to foreign
ownership, the NIEs all benefited from the same
principles that resulted in success. There were four
basic factors underpinning their success:
1. Firms benefited from low rates of interest, low
inflation, and high rates of saving within the
economies.
2. They all responded to the open and
outwardlooking export-led strategies that were
generally followed.
3. All the NIEs developed an appropriate human
resource development strategy that
complemented and provided trained workers
for the growing industrial sector. This included
engineering, technical, and vocational schools.
4. Government intervention was undertaken
whenever it was needed. At the outset, this
included the attraction of foreign industries by
Singapore because it felt that the local economy
was too weak to do it by itself.
Country Experiences
Hence, over the years, the Asian countries have actively
developed their electronics sector although there are
differences in their field of specialization owing to
differences in the labor force and technological
advances. For instance, South Korea and Taiwan have
well developed semiconductor industries, while Hong
Kong and Singapore dominate the disk-drive and
motherboard markets. Table 6.4 provides a ranking of
the major exporters of electronics in Asia since 1997. As
can be seen, Korea, Taiwan, and China appear to be
gaining the lead as major exporters, whereas Singapore
and the Philippines have slipped to ninth and twentieth
positions in 2000 from fourth and sixth places,
respectively, in 1997. Before we discuss comparative
advantage in the next section, we will first look at
various case studies in Asia to see how their electronics
sectors have evolved and developed over the years.
SINGAPORE Singapore followed a model of
attracting foreign enterprises (transnational
corporations or TNCs) to set up operations in
Singapore. These TNCs were initially attracted by low
labor costs, political stability, good infrastructure, and
an attractive environment provided by the government
which allowed foreign control and ownership of these
subsidiaries. Foreign direct investment was attracted
initially to the Jurong Industrial Park, including
enterprises such as Texas Instruments, General Electric,
and Hewlett Packard from the United States, Fujitsu
from Japan, and SGS from Italy. There were also various
attempts by the government to promote advances in
higher-end technology over the years but these were
frustrated by the economic downturns in 1974-1975
and 1985-1986. Nevertheless, upgrading of facilities
and technologies was a general practice as the TNCs
had to remain competitive in international markets.
In addition to physical infrastructure and favorable
government policies that supported the TNCs, the
development of telecommunications and transport
infrastructure made it an attractive corporate
headquarters site. By the early 1990s, there were more
than 300 TNCs located in Singapore from North
America, Europe, and Japan.
To provide a skilled labor force, the Economic
Development Board (EDB) supported technical training,
including engineering and technical schools to ensure
the growth of the industrial sector. The National
University of Singapore and Nanyang Technological
University were able to supply a very large number of
engineers and other technical graduates and craftsmen,
and this availability of low-cost and highly skilled
engineers and other workers has been cited as one of
the primary reasons for TNCs to locate in Singapore.
By the early 1990s, more than a third of value-added in
manufacturing was coming from the electronics
industry. Disk drives, integrated circuits (chips), and
printed boards were the most important exports,
totaling about US$7 billion, US$4. 5 billion, and US$3
billion, respectively.'1he three largest chip firms were
Texas Instruments, SGS Thomson of Italy, and NEC.
These firms and others upgraded their production and
technology over time.
Electronics production in Singapore is not the leading
edge but it has been upgraded continuously over time
so that new advances from the parent company have
been incorporated. Some backward linkages have also
been forged with local suppliers, and forward linkages
developed with Hewlett Packard and Canon. Singapore
was the world’s largest producer of disk drives in 1991
and this leadership extended into the 1990s. The
producing firms included Seagate and Canon
Peripherals. Plants graduated from production learning
to investment-led innovative learning. Consumer
electronics included products from Philips and AT&T. In
the case of AT&T, it took less than eight years to
develop a high quality of production with advanced
technology, taking advantage of the infrastructure that
had been put in place.
Owing to the emergence of China as a relatively
lowcost manufacturing base and the fast developing
technological capabilities of neighboring Taiwan and
Korea, competition in the international arena has
intensified and Singapore’s attractiveness as an
electronics manufacturing base has slipped in recent
years. This has been exacerbated by the slowdown of
the US economy, Singapore’s major trading partner,
leading to a subsequent decline in export demand and
overall economic growth.
In order to remain competitive, Singapore has
undertaken various measures to move up the
technology value chain. They include the shift of the
manufacturing focus from low-end products, such as
desktop computers, television sets (TVs) and audio
parts, towards high-end electronic components, such as
integrated circuits (le), transmitter receivers, and
optical disk drives. The Ministry of Trade and Industry
(MTI) has reported that exports o transmitter receivers
grew the fastest at more than 70 percent while certain
low-end electronic exports, such as personal
computers, declined by 20 percent between 1996 and
2000 (Ministry of Trade and Industry, 2002). Singapore
has also encouraged the development of stronger
linkages between local suppliers and the multinational
corporations (MNCs). Additional measures include the
promotion of other high-technology industries in ICs
and semiconductors, as well as the establishment of
closer ties with other Asian countries through the
signing of regional and free trade agreements. The role
of the latter is to open up new markets and promote
Singapore’s new role and capabilities as a producer of
high-end components and finished products.
KOREA Korea became a leader in the chip industry
and developed the capability to produce household
appliances (TVs and cassettes), as well as small
computers and peripherals. Most of the Korean
production was not at the technological frontier and
took place under OEM, and subcontracting and
licensing. TNCs were not welcomed. By the end of the
1990s, Korea had become one of the leaders in chip
production worldwide, holding a substantial share of
the DRAM (dynamic random access memory) market.
They moved slowly from OBM in the 1980s to ODM in
the 1990s, and there was a substantial increase in R&D
investment as the industrialization process continued.
The large chaebols, including Samsung, Lucky Goldstar
(LG), and Daewoo, were the centers of electronics
production as Korea followed the example of Japan in
developing large conglomerates. In selected product
lines, such as DRAM production, they have developed
to a point where they are challenging the Japanese
companies. They also face the same problems of
management and coordination.
TAIWAN Taiwan developed its electronics and other
industries using the same approach as Korea, in the
sense that it discouraged TNCs and instead set up
domestic firms using subcontracting, licensing, and
OEM/ODM. However, instead of building large
conglomerates as in Korea, they relied on small and
medium-sized industries which were fast, skillful, and
agile in developing new products and adjusting to the
intense competition in international markets. These
small and medium-sized industries were supported in
their development by government policies and the
availability of skilled technicians and managers supplied
by the educational system. Taiwan became a specialist
in the production of desktop and lap-top computers,
terminals, monitors, disk drives, peripherals, and other
computer components. Eventually, some of the small
and medium-sized firms became larger-Acer, for
example-as they moved toward OBM (own brand
manufacturing) from OEM and ODM. Because of the
focus on small and mediumsized operations, it was
important for Taiwanese businesses to develop
networks of subcontractors and forward linkages with
buyers in other countries. They also established
linkages with China, Hong Kong, Malaysia, and other
countries. They have become quite expert in this kind
of networking and now many of the components for
their computers are made in other countries, with
assembly either in Taiwan, China, or some other
location.
COUNTRIES IN SOUTHEAST ASIA The evolution
of industry' in Malaysia and Thailand has followed a
pattern similar to that of Singapore. In Malaysia,
electronics made a substantial contribution to
economic growth during the 1980s and 1990s. By the
end of the decade, electronics accounted for the major
part of total exports and of manufacturing output. The
electronics industry began in the 1960s when
Matsushita of Japan and other TNCs began assembling
radios, TVs, and electrical appliances. In the 1970s, an
export promotion policy was adopted and the
semiconductor industry took off as Intel and Motorola
began chip assembly. By the late 1980, electronics
became Malaysia’s largest export sector. The
production of consumer goods increased in the 1990s,
and there was further diversification of production into
disk drives, computers, and color TVs, mainly from
Japanese investors. Despite such rapid progress,
Malaysia’s R&D remains weak and the electronics
industry is sensitive to global swings in demand and
also to the vicissitudes of foreign investment inflows.
However, the active direction of foreign investment
inflows into various high-technology and capital-
intensive projects by the government has served to
enhance and upgrade the strength of its existing
electronic capabilities and to further improve
Malaysia’s attractiveness to MNCs. The government
has invested in effective infrastructures to heighten its
conduciveness to future investments. This includes, for
example, the expansion of Penang Port’s capacity to
handle one million twenty-foot-equivalent unit
containers by 2004.
In Thailand and the Philippines, the emphasis has been
on lower-level and simple electronics. In the
Philippines, the emphasis was on chip manufacture
while Thailand focused on computers, particularly hard-
disk drives. Both countries have followed the
Singaporean and Malaysian models of relying on TNCs
for technology transfer and production know-how.
There has been less development of local expertise and
backward and forward linkages.
THE ROLE OF INNOVATION
Some mention should be made about the importance
of innovation in the industrialization process. We have
already noted that education together with the
expansion of the labor force played key roles in
achieving economic growth in the countries of East and
Southeast Asia in the decades of the 1970s, 1980s, and
1990s. Growth in the labor force alone contributed
about 20 percent of total growth in income (see Bloom
and Williamson, 1999). In addition, Temple (2001)
suggests that education may account for one-fifth or
more of growth in gross output in the OBCD countries.
Much of the remaining growth in income resulted from
new innovations and the adaptation of innovation from
other countries. Innovation requires a creative process
of abandoning old ways of doing things and the
adoption of new methods and processes. To do this
effectively and dynamically requires the ability 0f the
economic system to facilitate the exit of inefficient
companies and the entry of new and more productive
ones. In East and Southeast Asia, the barriers to entry
include not only the need to have sufficient Capital, but
also to satisfy the government requirements in terms of
registration, labor, and other regulations, including
environmental and industrial codes. Entry costs are low
for small and medium-sized firms and exit is also
generally easy by declaring bankruptcy. For larger firms,
rules and regulations vary widely. In Hong Kong and
Singapore, costs are low while those in South Asia,
Indonesia, and Vietnam are high (Dlankov et al., 2002).
Exit is particularly difficult where large firms have a
hold on government agencies or where the fear of
adverse employment effects is great. For this reason,
many inefficient state-owned enterprises (SOEs) are
kept in business in large economies, such as China,
India, Vietnam, and Indonesia.
Innovation in Southeast Asia has primarily been the
result of spending by MNCs. In East Asia, innovation has
been developed through licensing arrangements rather
than MNC participation. Recently, the flow of
innovative investment began to respond to growing
human capital in East Asia, as Korea and Taiwan started
to build up strategic alliances with other firms in the
industrialized countries using information
communication technology (ICT) as a base. Thus, East
Asian firms often conduct research jointly with other
firms in Europe or the United States. For example,
Hsinchu Park (outside Taipei) and Silicon Valley have
developed multiple inter-firm associations, according to
Yusuf and Evenett (2002). The overseas Chinese
network also continues to build, shifting from low to
higher-technology industries. It has worked to
supplement and augment formal legal systems within
individual countries and to discourage opportunistic
behavior. This network also serves to informally
enforce standards and to generate information
exchange, thus enhancing networking capabilities and
developing better marketing skills.
Innovation and technology transfer have taken place
most often when capital equipment and components
are imported by export-oriented manufacturing firms
(Gill and Kharas, 2007). This is true for both low and
middle-income countries in Southeast Asia and some
countries in East Asia. These kinds of technology
transfer require a high level of external financing as
well as some local funding, highlighting the importance
of financial sector development as an enabler of
innovative change.The business sector plays a key role
in both funding R&D and implementing research
innovation in new and improved products. A large part
of R&D comes from the private sector in Southeast and
East Asia, including China (Gill and Kharas, 2007). State-
owned enterprises are notoriously slow to innovate
while some innovation comes either from other
governmental agencies or institutions of higher
education. While most innovation and knowledge still
flow from the industrial countries either through joint
ventures or foreign direct investment (FDI), some NIEs
are producing new knowledge that is on a par with
those at the frontiers in the industrial countries. These
breakthroughs are being shared among their neighbors
in the Asian region.
INNOVATION, EDUCATION, AND GROWTH
CONVERGENCE
The rapid growth in income in Southeast and East Asia
resulted in a strong convergence in growth between
these economies and the industrial countries. An
important component of this growth experience has
been the dynamism of the industrial sector and the key
role that technology transfer has played. Without the
mutual synergies created by technology, education,
openness, and competitiveness, such rapid growth
would not have been possible. An important additional
lesson is that the process of industrialization and
innovation is not necessarily linear and those countries
that get left behind have to employ a different strategy
to catch up with those who have moved forward and
acquired a leading edge in new developments. Nelson
and Phelps (1966) have argued that learning takes
place only when technology is changing. However, if
technology changes too fast then those who fall behind
can get lost, as noted by Findlay (1978). Leung (2003)
has pointed out that appropriate technology as
opposed to state of the art technology is the way for
these countries to move forward, and a way to access
this technology is through FDI Gill and Kharas (2007)
also pointed out that R&D not only increases with per
capita income but also accelerates at an increasing
pace.
What is important to emphasize here is the need to
develop an industrial growth philosophy and policy
framework that puts the various components of
industrialization in proper perspective. Countries
beginning industrialization need an entirely different
set of policies for education and technology transfer
compared with those economies at a more advanced
level. However, to become equipped they will still need
some of the modern tools of technology, including
computers and information technology.
Furthermore, even when the initial conditions in terms
of infrastructure and education are in place, the
adoption of new innovations can often be torturous.
Hobday (1995) and ADB (2003) have emphasized that
the subsidiaries of MNCs and local firms that assemble
goods according to standard processes often had
difficulty in becoming competitive and maintaining it.
The process began in the 1960s and 1970s with OEM
and then moved to ODM in the 1980s, and finally to
some OBM in the 1990s, particularly in Korea and
Taiwan, but also in Malaysia.
EMPLOYMENT GROWTH AND
INDUSTRIALIZATION
How does employment grow in a country that is
industrializing rapidly? It will depend upon the rate of
capital accumulation and technical progress. When
technical progress is labor-intensive, it will help
employment, and when it is capital intensive, it will
retard the growth in employment. This is a simple yet
powerful concept. It is also important that wages be
flexible, otherwise labor can be priced out of the
market and capital used instead.
This is the risk that faces labor unions and other
institutional factors that limit labor mobility.
Employment growth is directly related to output
growth as well. Using the case of Asia, we observe that
no rapidly growing Asian economy has had an
employment problem in the long term, at least until the
Asian crisis. This is partly because growth was so rapid
that it was easy to absorb the labor generated by rapid
population growth. However, it was also the result of
selected production methods that was fast
laborabsorbing at a low level of technology (that is,
laborintensive industries like apparel, footwear, and
leather products) and later, partly labor absorbing at a
higher level of technology (such as electronic assembly,
data inputting, and software development).
All the NIEs and Malaysia and Thailand were running a
fully employed economy. Indonesia and Vietnam also
improved and the Philippines showed signs of growth
that eventually helped the employment situation. In
South Asia, which grew more slowly, there was still a
lot of underemployment.
THE ROLE OF THE GOVERNMENT
Generally speaking, government policy .in the industrial
sector has adopted a hands-OE attitude in terms of
providing direct incentives for individual industries. This
is particularly true in the case of Taiwan, where there
are no Specific industries supported by the
government. In the case of Korea, strong industrial
policies were advocated and the emphasis has shifted
over time. Nevertheless, a bias toward particular large
industries has been maintained. In Southeast Asia, a
more balanced attitude has prevailed, with few
subsidies or promotional advantages offered.
Nevertheless, the industry has been nurtured in a
number of ways.
Nurturing Growth in the Industrial Sector
Industrial sector growth was nurtured in many ways
through the indirect effects of government policy,
Exchange rates were maintained in such a way that the
industrial sector was not penalized. Educational
opportunities were enhanced through a continual
buildup of technological capacity, particularly in Korea
and Taiwan. Furthermore, infrastructure spending was
maintained so that transport, communications, and
information technology could be used to enhance
innovation and productivity. Where policies allowed for
the free entry and exit of business firms, a flexible
environment conducive to rapid change and adaptation
to new techniques and ideas flourished and economic
growth accelerated. Finally, labor market policies, even
when unions started to grow in the past decade, were
flexible enough to allow firms to adapt to changes in
demand.
In cases where such industrial policies were not
followed, industrial growth has been slower and less
flexible. This has been particularly true in those
economies where SOEs have established a strong
foothold, such as in India and other South Asian
countries, and also in Vietnam and parts of the Chinese
economy.
Efficiency and Welfare
When markets work well, resources are allocated in an
efficient manner. We have seen that this has generally
been the case in the evolution of rapid industrial
growth in East and Southeast Asia. There have been,
however, cases when there was market failure. We saw
how the bubble preceding the financial crisis led to a
misallocation of resources in several economies in the
Asian region. Markets may also fail to allocate
resources effectively in cases where there may be
elements of a natural monopoly, although recent
developments in public utility economics suggest that
these elements are less widespread than previously
believed. There are also considerations of welfare that
have to be taken into account that go beyond the
operation of simple market principles. The provision of
unemployment and retiremel1t benefits is part of the
fabric of industrial policy in the industrial countries. Yet,
these are only now being developed in the Asian
economies. This area requires a growing share of
resources as populations begin to age. Japan is now
grappling with these issues, particularly since its
population is aging faster than other industrial
countries.
To some extent there is a trade-off between efficiency
and welfare. We will not dwell on this but need to
recognize the necessity of planning for retirement and
that a social safety net should be provided for workers
that are retrenched in periods of slack demand. In the
past when the region was experiencing unparalleled
growth, these considerations were less important. Now
that growth has slowed and unemployment has
increased, these issues have become more pressing.
ECON (WEEK 4) THEORIEs OF INTERNATIONAL TRADE
Gains from Trade
An introduction to international trade usually begins
with an autarkic economy. Such an economy can
consume only as much as it can produce. Thus, it would
be motivated to produce only what it can consume and
cannot exploit any economies of scales that may exist.
When trade is introduced, the economy can gain
through two main avenues: consumption and
production.
CONSUMPTION GAINS With trade, it is possible to
reach higher indifference curves through gains realized
by consumers. The gains from trade are illustrated in
Figure 7.1.
PRODUCTION GAINS Trade enables the production
and reallocation of gains by allowing countries to
specialize in the production of commodities at a
relatively lower cost either because of absolute
advantage or comparative advantage. The production
gains from trade also arises because of expanded
production, through utilizing economies of scale
resulting from larger markets, or technology transfers
which help to expand the production possibility
frontier. Trade also enables a country to purchase raw
material and intermediate products not available
locally. The major difference between absolute
advantage and comparative advantage is that in the
former case, the country can produce the commodity
more efficiently (in absolute terms). To have
comparative advantage means that the commodity can
be produced relatively more efficiently.
The gains from trade can be broken down into gains
from exchange and gains from specialization.
In this model based on Ricardo (1817), for the sake of
simplicity, it is assumed that there are only two
countries and two final products. A production
possibility curve (a straight line in figure 7.1) shows the
production combinations of the two goods in a single
country. The goods are produced using labor input L,
which is assumed to be homogeneous and supply
inelastic, perfectly mobile domestically but
internationally immobile. Labor requirements per unit
of output are fixed and do not vary with the scale of
production. Technologies differ between the two
countries and there are no trade barriers or
transportation costs. There is competition in both
factor and product markets.
Without trade (autarky), it will be optimal for a country
to consume the two final goods produced at point A,
where the indifference curve intersects the production
possibility curve. With trade, the country will be able to
specialize in the production of a final good where it has
a comparative advantage, and the production
possibility curve would pivot outwards from point T1.
The optimal point would be to the right of A, at the
intersection of the new production possibility curve and
a higher indifference curve. Hence, it can be seen that
trade allows a country to enjoy greater consumption of
goods.
Another production possibility curve that intersects A is
constructed in Figure 7.2 so as to demonstrate the
effects of a change in the relative prices of the two
goods as a result of trade. Production remains
unchanged. When the second good is cheaper, more of
it will be consumed. The shift in consumption from
point A to B displays the gain in utility from the
increased consumption of the second good because of
the change in relative prices. The subsequent move
from B to C represents the increased specialization in
production. These two effects are the same as those
found when we look at the income and Substitution
effects of a change in the price of a good in
conventional demand analysis. The move from A to B is
the substitution effect (no change in income but only in
relative prices) and from B to C, the income effect.
Gains from trade can be derived analytically. The main
finding according to the Ricardian model is that
countries will benefit from trade in proportion to the
degree to which their labor productivity is different. In
addition, trade will be beneficial if there are favorable
terms of trade to the home country. This is in keeping
with intuition.
Ricardian Theory of Trade
The Ricardian theory says that differences in
technology determine comparative advantage. The
theory considers the units of labor or labor hours
required to produce a unit of a certain commodity. A
major point from the Ricardian model is that trade
patterns can be explained by technological differences
or labor productivity differences between countries.
Trade is a positive-sum game and therefore there are
no losers across or within countries. Countries need not
be competitive relative to the other country to gain
from trade. However, the model gives no explanation
for the differences in labor productivity that arise
between countries, or how and where changes in
productivity arise and occurs. This deficiency is
addressed by the Heckscher-Ohlin (Heckscher, 1919;
and Ohlin, 1933) theory, which was incorporated into a
general equilibrium framework by Samuelson (1948).
The theory has therefore been labeled the
HeckscherOhlin-Samuelson (HOS) theory.
Heckscher-OhlinTheorem
According to the Hecksher-Ohlin (H-O) theorem,
countries will specialize and trade in goods which are
relatively abundant. Thus, labor-rich countries will
specialize in the production of labor-intensive products
while countries with abundant capital relative to labor
will specialize and trade in commodities that are capital
intensive in nature. Extensions of this theory can
include skill or education-intensive goods as well.
As a result, it is expected that poorer countries will
export labor-intensive products while the rich countries
will export capital or skill-intensive products.
The basis of the model is that countries differ from one
another according to the factors of production they
possess, and that goods differ from one another
according to the factors of production. Thus, a
laborabundant country will have a comparative
advantage in a good that uses labor relatively
intensively (for example, sweaters require machine and
yarns, while bread depends on agriculture and
farming). . According to the Heckscher-Ohlin theorem:
. . . .trade should be greater between countries that
have the greatest differences in economic structures. If
there were no differences in the HOS model, there
would be no trade whatsoever.
. . . .factor prices will tend to level out as trade
continues. This is called the factor price equalization
theorem. In a country that has a comparative
advantage in labor-intensive products, its wage rate will
be low relative to a country that has a comparative
advantage in capital-intensive products. As trade takes
place, the country producing labor-intensive products
will experience an increase in labor relative to‘ capital
and thus, the demand for labor will rise relative to the
demand for capital and so will the wage rate relative to
the cost of capital. Similarly, in a court try producing
capital-intensive goods, the return to capital will rise
relative to the wage rate.
The Rybczynski theorem (Rybczynski, 1955) says that if
capital-labor ratios differ between industries then, at
constant commodity prices, an increase in the supply of
one factor alone will cause the expansion of the good
intensively using that factor and a decline in the supply
of the other good. The Stolper-Samuelson theorem
(Stolper and Samuelson, 1941) says that an increase in
the price of any good raises the nominal, relative, and
real return to the factor in the production of that good
and lowers the nominal, relative, and real return to the
other factor.
Imperfect Competition
Both the Ricardian and the HOS models establish a
linkage between economic efficiency,
factor endowments, and the direction of international
trade. They make many simplifying assumptions,
including the existence of perfect competition in
'commodity, factor markets, and the homogeneity of
production factors. They also assume that factors are
immobile between countries, consumer
preferences and production functions are identical,
and consumers have identical preferences. They also
assume that there are no taxes, costs of transport, or
other barriers to trade.
When these assumptions are relaxed, there is a
probability that the conclusions of the models may not
hold. In particular, there are two aspects of
international trade in which these models are deficient
when confronted with the actual flow of international
trade. First, the model suggests that there should only
be a small amount of trade between countries with the
same factor endowments. In fact, most of the world
trade that takes place between rich countries have very
similar factor endowments. Secondly, neither theory
considers intra-industry trade, which has shown a
significant increase.
To address these aspects, the theory of imperfect
competition (oligopoly and monopoly) is applied to
international trade. In this framework, the direction of
intra-industry trade is determined in large part by
differences in relative factor endowments while
production differentiation and relative market size
determine the volume and composition of international
trade.
In models of trade with imperfect competition, greater
trade between countries with similar factor
endowments arises because of product differentiation
and differences in consumer preferences. However,
because of the existence of monopolies and the
introduction of scale economies, the gains and
direction of trade are complex and difficult to analyze.
If trade results in a decrease in market power and the
distortions that come with it, then there could be
welfare gains from trade as well as from scale
economies. However, if the gains from trade are
realized in sectors where there is monopoly power,
then trade would result in a decrease in competition
and an increase in monopoly elements. This could lead
to a decline in welfare. In summary, the direction of
trade will depend upon the comparative advantage
gained from trade, as well as the relationship between
the size of the country and its imperfectly competitive
industries.
With regard to intra-industry trade, the theory states
that the more alike countries are in terms of relative
factor endowments, the larger the share of
intraindustry to total trade.
Much of the empirical work that has been carried out
as well as casual observation seem to confirm the
theoretical implications of the monopolistic
competitive model. Trade between countries with
similar factor endowments has grown as a proportion
of total trade. Furthermore, the ability of large
oligopolies within a country to distort prices and reduce
the supply of goods may have been hampered by the
requirement to be competitive internationally.
However, there may be cases where this pressure is
lessened by the introduction of tariffs to protect
domestic markets. The case of Japan comes to mind.
As far as empirical evidence for the validity of the
theoretical inferences of models with monopolistic
markets is concerned, there is some positive support.
The gravity model of international trade, which asserts
that the distance between countries and their relative
physical sizes are the main determinants of trade, has
received wide confirmation in many empirical tests.
Correlations have also been found between the extent
of intra-industry trade among country pairs and
percapita income, and also between intra-industry
trade and measures of cross-country differences in
percapita income. In the latter case, the correlations
are negative as expected.
The positive relationship between intra-industry trade
and per-capita income is explained by similarities in
tastes being correlated with per-capita income.
Countries that are more alike, as measured by per
capita income, would have a greater tendency to trade
with each other in products in the same industry.
Automobiles and other consumer durables are good
examples.
INSTITUTIONAL FRAMEWORKS THAT
FACILITATE TRADE Currency Exchange Rate
The currency exchange rate is by far the most
important factor in deciding trade policy. Since the
exchange rate determines the international value of
the domestic currency, it directly affects the
profitability of firms producing for the international
market, or firms facing foreign competition. Economists
use the concept of an equilibrium exchange rate to
determine whether a currency is overvalued or
undervalued. There are many ways to measure this.
One way is to base it on the market. If the market for
foreign exchange is free, it will determine the
equilibrium rate.
Suppose there is a free trade regime and an equilibrium
exchange rate during this regime. An across the-board
tax on all imports is levied. What happens? The
demand for imports declines as domestic prices are
raised to reflect the tax. As the demand falls so also
does the demand for foreign currency to pay for these
imports. What then happens to the exchange rate? In a
supply-demand framework, the demand for the foreign
currency has fallen and so will its price. Thus, the
domestic currency will increase in value vis-a-vis the
foreign currency. If there is an export subsidy or tax
break, what happens? The currency tends to
depreciate. Other things being equal, import-
substitution will result in a currency appreciation, and
export promotion will result in currency depreciation.
As this process takes effect on the exchange rate, it
reinforces the particular policy followed. Depreciation
in the exchange rate brings greater international
competitiveness to the country, while a currency
appreciation makes exporting more expensive and
domestic production more attractive.
Capital Movements
International capital markets became more competitive
and open during the 1980s and 1990s. Funds could
move freely into the developing countries. In the
1970s, most of the international capital movements
were in the form of loans from Western banks-
primarily those from the United States-into Latin
America. There was not much equity investment and
the private sector was not involved to a great extent
(such as bank lending to firms in Latin America). In the
1980s and particularly in the 1990s, markets in Asia
opened up. This time there was a significant increase in
portfolio investment and short term bank lending to
the private sector.
Other Factors
While many developing countries would have given
their right arm to be in the same situation as the NIEs
and the economies of Southeast Asia during this period,
these economies also went off the rails following the
Thai baht devaluation in mid-1996. The rapid build-up
of foreign inflows had implications for a number of
stabilization issues. The most critical was the current-
account deficit.
THE CURRENT-ACCOUNT DEFICIT. How large
can or should the current-account deficit get? The
economics profession has not reached a consensus on
this. From the point of view of a developing country
with good investment potential, the current-account
deficit can be at any level, as long as the investment
which it finances is more productive than in alternative
uses elsewhere. The point here is that the developing
countries are usually capital scarce and labor rich at the
beginning of their development. Thus, the returns to
this scarce capital are high and remain high for some
time. However, there are constraints.
ABSORPTIVE CAPACITY High investment rates of
40 percent of GDP (Shirazi, 1998, p4) require
complementary inputs of labor and some of this
investment must be in infrastructure to support
investment in machinery and new plants. Thus, there'
IS a supply side constraint which puts a ceiling on the
amount of investment that can be absorbed without
introducing a troublesome loss of efficiency and costly
bottlenecks.
PRICE STABILITY AND COMPETITIVENESS The
second constraint is price stability and international
competitiveness. Most of the economies in question
have maintained a close relationship between their
currencies and the US dollar. During the decade
following the Plaza Accord, the dollar depreciated
against many other currencies, including the Yen, and
those economies that stuck with the dollar benefited
internationally. Those countries that maintained stable
price regimes benefited the most, since their domestic
inflation rates were as low as or lower than their
trading partners. When inflation rates crept up as a
result of continued rapid growth and capacity
constraints and the US dollar strengthened against the
yen, several of these countries began to lose their
competitiveness, reflected in the lower export earnings
during the first half of 1996.
THE ASIAN EXPERIENCE IN INTRA-INDUSTRY AND
INTRAREGIONAL TRADE
With regard to the composition of international trade,
as the level of development increases, the thrust of
trade is toward exporting more manufactured goods.
The structure of imports remains relatively unchanged,
although there will be a shift from finished
manufactured goods imports to capital goods and raw
materials, as well as semi-finished or unfinished inputs.
lntraregional Trade
We have already discussed in some detail the
importance of international trade and the role of
exports in raising incomes and stimulating the
economies of the region. Let us now look at the role of
intraregional trade, immigration, and capital
movements and how they have affected the growth
and development process in the region. We begin by
noting that the share of Asian (including Japanese)
trade in total exports and imports of the Asian
countries has increased greatly in the last two decades.
We can then pose the following question.
Why Has the Share of Intra-Asian Trade in Total
Asian Trade Increased so Much Over Time?
There are four basic reasons why this has occurred.
First, the growth in income and the geographic
proximity within the region have stimulated trade. This
is to be expected, as there is considerable evidence
that, other things being equal, trade is more likely to
take place between countries which are close to each
other. Secondly, there has been rapid growth in
different kinds of regional cooperation arrangements
that have facilitated trade. Thirdly, other factors such
as fluctuating exchange rates, technological
developments in telecommunications, and lower
transportation costs have helped to stimulate trade
within the region (see Box 7.1 for the role of Singapore
in the production of hard-disk drives in the electronics
industry.). Finally, as incomes have grown and
developing Asia has begun to produce more
manufactured goods, their trading pattern has begun
to resemble that of the OECD countries. They are
beginning to trade more in industrial products where
there is a higher degree of product differentiation.
The example of Singapore in the production of harddisk
drives also points to the importance of developing a
skilled and flexible labor force and the maintenance of
an open trading environment that is able to attract
significant inflows of FDI.
Rapid Economic Growth and
Geographical Proximity
Other things being equal, we would expect to see more
rapid growth in trade between countries that are
growing rapidly than between countries which are
growing slowly. If the elasticity of import demand are
the same between a slow growing and a rapidly
growing country, then the latter will have a faster
increase in imports than the former. Since Asia is
generally a rapidly growing region, the share in trade of
these countries in the overall trade of an individual
country would increase. The close proximity of these
countries in Asia compounds this trend. Research has
shown that the shorter the distance, the more trade
will take place. This is because of lower transportation
costs but also the better knowledge about and
familiarity with the nearby countries. As more
complicated production and supply chains are
developed, as seen in the example of Singapore,
airfreight services become more important for
maintaining and extending the production networks
and supply chains. According to Yusuf and Evenett
(2002, p. 153):
. . . . .for an East Asian economy to protect its national
carrier from competition in its domestic market is
highly disadvantageous. Protection lessens the airline’s
motivation to improve its reliability and reduce transit
and transhipment times. Development of ICT has made
processing orders and scheduling pickups and deliveries
more efficient, as demonstrated by Federal Express’s
operations throughout East Asia.
Shifts in the Direction of Trade
Intraregional trade in East Asia has expanded at a more
rapid pace than trade with the rest of the world. It now
accounts for more than half of the trade volume in the
region (including Southeast Asia). This is the result of
the continuing division of labor combined with the
growth of manufactured goods in total trade, and is
characteristic of all countries in the region (see Table
7.5). This expansion in intraregional trade is not
because there has been a shift away from trade with
the rest of the world Rather, it has resulted from the
development of a triangular pattern of exports (see Gill
and Kharas, 2006) whereby the East Asian NIEs and
Japan ship parts to China and ASEAN where processing
is completed and then shipped to markets outside Asia,
such as the European Union, the United States, and
Canada. This new pattern of trade has been particularly
strong for products such as electrical appliances, office
equipment, telecommunications equipment, and
textiles and apparel.
Shifts in Commodity Composition of Trade
There has also been a shift in the commodity
composition of international trade where exports have
moved from light manufacturing, including textiles,
wood and paper products, and furniture, to machinery,
particularly electronics and telecommunications
equipment. This shift was particularly rapid among the
ASEAN countries (except Indonesia).
This new pattern of trade and production networks is
an extension and deepening of outsourcing that
originated in Japan after the Plaza Accord of 1985. The
main reason was to reduce costs by locating the
production process near sources of consumer demand
and to centralize production to take advantage of
agglomeration economies, as well as to facilitate and
disseminate new technologies. It should be noted that
the pattern of trade is vertical rather than horizontal in
nature. Vertical trade is characterized by products of
different quality and price, such as for standard-color
and hi-definition televisions, whereas horizontal trade
involves products that are similar in function, price, and
quality. These horizontally traded products differ only
by design or other minor characteristics. Most trade in
East Asia is vertical and commonly includes goods such
as footwear, garments, and electronics, as well as in
components of these products. This means that several
different countries can participate in different stages of
a single production chain. A personal computer, for
example, may have its keyboard, central processing
unit, screen, and other components made in different
countries but assembled together at the final location.
Other Factors
EXCHANGE RATE ADJUSTMENTS Following the
Plaza Accord in 1985, the realignment of currency
exchange rates brought about a shift in comparative
advantage and improved the competitiveness of Asian
exporters who remained tied to the US dollar. This has
been reflected not only in the changing pattern of trade
but in a shift in the pattern of production with the
transfer of some manufacturing activities from Japan
and Taiwan to lower wage countries in Southeast Asia
and also to China. The increase in trade in capital and
intermediate goods as a result of these transfers of
production platforms away from the NIEs and Japan
has contributed to the rapid growth in intraregional
trade in Asia.
REDUCTION IN TRANSPORT COSTS Lower costs of
transportation and the development of more efficient
port facilities in Southeast Asia have also contributed to
growing intraregional trade. There, is substantial
evidence that the costs of transportation have been
lowered as a result of better port handling facilities and
the development of larger cargo ships. Between 1990
and 2004, freight costs as a percentage of import value
fell from about 10 percent to 8 percent, lower than any
other developing region but still higher than freight
Costs for the developed countries. (For further details,
see Yusuf and Evenett, 2002; and Gill and Kharas,
2006).
IMPROVED TELECOMMUNICATIONS New
technology in telecommunications, particularly in the
use of fax and e-mail, has complemented the decisions
by many multinational firms to adopt production
platforms in different locations. The desktop computer
is a good example, since the components are often
produced in several different locations and then
shipped for assembly in yet another location.
LIBERALIZATION OF REGULATIONS ON FOREIGN DIRECT
INVESTMENT The liberalization of capital flows has
followed, usually with a lag, the liberalization of trade.
Liberalization of regulations on FDI has proceeded hand
in hand with other factors to facilitate the growth in
trade, particularly in intermediate goods.
It should be kept in mind that these factors are not
necessarily additive. There are interaction effects that
are difficult to capture in a simple statistical analysis.
For example, the increase in incomes and lower tariffs
has given consumers more options to explore products
from neighboring countries, and to trade with those
who have a similar cultural heritage.
INTELLECTUAL PROPERTY RIGHTS Intellectual property
rights (IPRs) have become an important factor in
determining the flow of FDI in selected industries.
Generally, IPRs have been trade-related and applied
asymmetrically across countries and this has distorted
the pattern of world trade. The structure of IPRs policy
can also have a significant impact on FDI, if the
products need IPR protection and the enforcement of
such protection is weak in a host country. Furthermore,
in order to control and protect their intellectual
property, firms may choose FDI rather than licensing
(Saggi, 2002, for further details of research in this area,
most of which is theoretical). In terms of its effect on
growth,
Gould and Gruben (1996) have found that a
strengthening of IPR protection is more conducive to
growth when it is accompanied by a liberal trading
policy. This could he because trade liberalization
curtails local monopoly power but enforces IPRs that
are truly global in nature.
INDUSTRIAL ESTATES The setting up if industrial estates
is one way that governments give an indirect subsidy to
business firms locating in the region. The development
of industrial estates has been a major vehicle for the
governments of several countries, including China and
the countries of Southeast Asia, to promote labor-
intensive manufacturing. Tax concessions and duty
drawbacks, together with infrastructure, are the main
inducements in these schemes.
TRADE IN SERVICES
The share of services in total international movement
of goods and services grew to about one-fifth of total
trade and services by 2001, reaching about US$1.4
trillion, according to Yusuf and Evenett (2002). Services
grew even faster than trade. Financial services
comprise the major part of business services which
support trade in manufactured goods that has been a
critical factor in economic development in Asia.
Services trade is also an important component of the
balance of payments for developing countries in Asia.
By 1997, trade in services made up a substantial share
of total exports in several Asian countries, almost
reaching the OECD average (see Table 7.6).
Part of the reason for the wide variation in the share of
services in international trade has to do with historical
traditions. In Japan, there is a lack of emphasis on trade
in goods and financial services, one of the major
components of services trade. This is also the case for
countries that have copied Japan, such as Korea. The
Philippines, having followed the US model, has given a
greater emphasis on services trade and this has been
complemented by a rapid development of software
exports and management services to the rest of Asia.
Hong Kong, being an entrepot port that has become a
servie center for much of the trade from China, also has
a large services sector. Singapore too has a high
developed services export industry, although it is
smaller than that of Hong Kong, as it has a strong
electronics industry that is primarily export-oriented.
The underdevelopment of the financial sector in many
Asian countries has also played a role in the slow
development of business services. However, it can be
noted here that the lack of a widely diversified and
internationally competitive financial apparatus in Asia
has meant that many of these services have been
supplied by the industrial countries, particularly the
United States.
The Yusuf and Evenett (2002) report also points out
that this lack of service acumen in the supply of
financial services internationally also applies to other
business services, including legal and accounting
services. The supply of these services is also tied to the
location of head offices and regional headquarters for
large multinationals. Hong Kong has a strong lead in
this area, primarily because of the substantial FDI
inflows that it managed to build before 1980.
Typically, high-technology business services in Asia
remain underdeveloped compared with manufacturing
technology. This can be traced partly to the shortage of
personnel, particularly in non-English-speaking
countries such as China, Indonesia, and Thailand, and
also the result of an industrial strategy that followed
the Japanese model to a significant extent, putting
more emphasis on hardware than software.
Furthermore, in the transition to higher value-added
products for export, a similar transition to higher value-
added services to complement the manufacturing
operations was not carried out.
ISSUES IN INTERNATIONAL TRADE AND THE BALANCE
OF PAYMENTS Level of International Reserves and the
CurrentAccount Balance
Since the Asian financial crisis there has been a
dramatic shift in the current-account balance and the
level of reserves of the Asian economies. This reflects
the weaknesses of those countries that did not have a
strong reserve position and were experiencing
significant current account deficits. The economies with
large international reserves were able to hold their
exchange rates steady (such as Hong Kong and China)
or suffered only modest depreciations (such as
Singapore and Taiwan) while the other crisis countries
suffered extensive currency weaknesses. For a panel of
Asian economies, reserves doubled to nearly
US1trillionin2002fromjustunder500 billion in 1996. By
the end of 2008, reserves had risen further to more
than US$33 trillion. This has been accompanied by a
significant turnaround in the balance of payments.
Are reserves too high? Using the traditional measure of
three months of import cover as a minimum, all the
crisis countries, except Korea, had an adequate import
cover in 1996, before the crisis. A more demanding
standard is the ratio of reserves to short-term external
debt, particularly if there i5 a likelihood that access to
foreign borrowing may be cut off. In 1996, three crisis
countries did not have sufficient reserves to meet this
standard (Malaysia and the Philippines did). However,
with the rapid build-up in reserves since the crisis, all
the crisis countries and China were able to meet this
more stringent requirement by 2008. This suggests that
the ability of the Asian crisis countries to face extern
shocks has greatly improved. In addition, many
developing member countries of the Asian
Development Bank are projected to continue running
significant current-account surpluses and accumulate
further reserves over the medium term.
Has the reserve buildup gone too far? To maintain a
higher than optimal level of reserves is costly since
these reserves earn low rates of interest and they could
be used to prepay expensive external debt.
This has happened selectively but the question is
whether central banks should be more aggressive in
reducing the level of external debt by using their high
level of reserves
Should Capital Flows Be Regulated?
Since the Asian financial crisis, there has been a
debate about whether short-term capital inflows
should be controlled. Those advocating controls note
the destabilizing role that short-term portfolio
movements had in creating a speculative bubble in the
mid-l9903, and then in destabilizing the economies
once the crisis had begun by withdrawing these funds
en masse. The critics also point out that while short-
term trade credit is a critical necessity to finance
international trade, portfolio investment and short-
term lending do not carry with it the desirable features
of bringing innovation and new technology and
business practices that come with foreign direct
investment. It does, however, provide increased
liquidity to the industrial sectors of the recipient
countries. Is that enough to justify the possible
destabilizing effects of portfolio and other short term
lending and investment?
Joseph Stiglitz (1998) has made some suggestions with
regard to this question. He suggests the elimination of
tax and regulatory and policy distortions that have
stimulated these flows in the past, such as the Thai
policy of encouraging short-term external borrowing.
He also suggests that banking regulations should be
strengthened to limit foreign currency exposure.
Should countries go so far as Chile, which taxes short-
term loans? This would depend upon individual country
circumstances. In addition, Stiglitz suggests that the
international community needs to consider the issue of
who should bear the costs of risky decisions. Up to now
it has been the lender. Stiglitz believes that there
should be some sharing of risk and responsibility. If
such a scheme were widely adopted, it would serve to
reduce the volatility and riskiness of short term
international lending.
The global economic crisis of 2008 and 2009 that
originated in the subprime mortgage failure in the
United States, which subsequently spread to the rest of
the world, has highlighted the importance of
developing a stronger regulatory apparatus both
domestically and internationally. The sale of so-called
toxic mortgage-backed securities to both financial
institutions and nonbank financial intermediaries-an
area that is currently not well regulated-compounded
the crisis and facilitated the spread to the rest of the
industrial countries and eventually, to the developing
countries as well. The failure of existing regulatory
institutions to monitor and control these assets led to a
pyramid of risk which was not well understood either
by the financial institutions themselves, the regulatory
agencies, or the general public. Discussions on
appropriate controls are now on-going in the United
States and other OECD countries as well as in
international institutions, such as the World Bank, the
International Monetary Fund (IMF), the Asian
Development Bank, the World Trade Organization, and
the United Nations. Although policy efforts are now
focused on a recovery from the on-going global
economic crisis, there have also been proposals for
modifying the international financial architecture and
funding modalities.
A proposal to increase the capital of the IMF has
widespread support, as do suggestions for
strengthening domestic institutions in the OECD
countries, as well as international regulatory agencies,
such as the Bank for International Settlements.
INDUSTRIALIZATION
The main structural development that separates a
modern high-income economy from a traditional
lowincome economy is the rapid development of the
industrial sector. Capital accumulation fuels the
development of the industrial sector.
The Asian Experience with Industrialization
- The first thing to note about the Asian
industrialization and growth experience is that it
was unprecedented in economic history.
- According to the World Bank (1993) and Quibria
(2002), from the mid 1960s to the late 1990s,
growth rate of the East Asian economies (Hong
Kong, Korea, and Taiwan) together with
Singapore in Southeast Asia – sometimes called
the Asian “tigers” or the Newly Industrialized
Economies (NIEs)- grew at a faster rate than
other economies had in the world. Per capita
incomes increased by about 7 percent per year,
so that income doubled every ten years. At the
end of thirty years, incomes per capita had
increased fourfold.
- Furthermore, during the same period, share of
GDP of the countries above also increased
sharply.
Interaction between the industrial and
agricultural sector.
- There is assumed surplus of labor in the
rural/agricultural sector. The supply of this is
virtually unlimited and the opportunity cost is
virtually zero.
- By removing the excess labor from the
traditional sector (agricultural sector) and
moving it to the industrial sector, the
productivity of labor increases. Furthermore,
the productivity in the rural sector also improves
since there are fewer workers – the surplus
workers have been removed.
- The surplus labor movement into industry
provides a net gain to the society. If the total
output of the agricultural sector does not fall,
then the food production is unchanged and the
transferred workers will be fed by the
agricultural sector, which will also be adding to
output in the industrial sector.
- Once the stock of surplus labor is exhausted, the
process of industrial development becomes an
interplay between two sectors as the wage rate
is driven up in both sectors.
- It is important to keep the terms of trade
between these two sectors on an even keel, that
is, if the terms of trade move too strongly
against the agricultural sector, they will not be
able to buy enough equipment to fuel
technological developments in the sector; by
starving agriculture, industrialists will choke
themselves to death in the long run. If the terms
of trade turn against industry, then industrial
investments will not be profitable and
investment will slow.
Backward and Forward Linkages
- It is through this that the interaction between
the industrial and rural sectors can be studied.
- Analysis of changes of these linkages can also be
helpful in assessing the progress of an economy
in its efforts to industrialize.
Indirect Backward Linkages
- These are the secondary effects which growth in
an industry has on its suppliers. Industries that
have strong backward linkages have low value-
added and a large input from local suppliers.
Examples of industries with strong backward linkages
include leather, clothing, textiles, food and beverages,
and paper.
Examples of industries with low backward linkages are
agriculture, public utilities, mining, and services.
Forward Linkages
- Tell us how a product is related as an input into
the production of a product at the next
stagetextiles to apparels, or petroleum into
plastics.
- They are a good indication of the extent to
which an economy can upgrade its industrial
base by using its existing expertise and resource
base.
Some Asian Countries’ Crisis Experiences and Recent
Developments ( from the sharings of Research
Outputs )

Philippines
- Was known as one of the richest countries in
Asia-2nd largest economy behind Japan after
reconstruction following World War II
- The country’s economy has been described as
resilient so as its people
- Philippine currency experienced depreciation of
more than thirty percent as with Indonesia and
Malaysia
- One of the causes of its economic crisis is due to
corruption by the government
Malaysia
- electronics made a substantial contribution to
economic growth during 1980s and 1990s
Indonesia
- Southeast Asia’s largest economy
- It is regarded as geographically strategic since it
is between Asian and Australian continents
Vietnam
- became the 150th member of the World trade
Organization in 2007 which marked a major step
in its economic journey
- ranked 48 out of 157 countries and territories in
terms of Human Capital Index and second in
ASEAN Countries
Thailand
- The 1997-1998 economic crises started
affecting other neighboring countries in Asia
- Its economy was a shift from “flavor-of-
themouth” to “stink-of-the-mouth”
- It has a floating exchange system
- depreciation of its currency reached up to more
than thirty percent during the Asian crisis
China
- the fifth largest economy and the third largest in
trade in the world
- known for its technological advancements
- there was no experience of depreciation of its
currency along with Hong Kong
Japan
- the “Lost Decade”- experienced the longest
economic crisis
- companies and consumers who saved too much
and the country’s aging population were
identified to cause the economy to slow down
Korea
- chip industry leader
- developed the capability to produce household
appliances
- production moved from OEM (own equipment
manufacturing) to ODM (own design
manufacturing)
- depreciation of its currency reached up to more
than thirty percent
Bhutan
- had the rupee crunch crisis
- the crisis was a combination of three other
crises namely trade, financial management, and
individual lifestyle (“ a poor country with rich
people”)
Singapore
- followed the model of attracting foreign
enterprises-Transnational Corporations ( TNCs)
to set up operations. These TNCs were initially
attracted by low labor costs, political stability,
good infrastructure, and an attractive
environment by the government
- world’s largest producer of disk drives during
1991 and this leadership extended into the
1990s
- its currency also depreciated significantly
smaller at twenty percent maximum with
Taiwan
Brunei
- has the 2nd highest Human Development Index
among the Southeast Asian nations
- 5th in the world by GDP per capita at Purchasing
Power Parity according to
 International Monetary Fund

Taiwan
- set-up domestic firms using subcontracting and
licensing

- specialist in the production of desk-top and

laptop computers, terminals, monitors and
other computer components
WEEK 1
Lesson Proper:
SOME SAVING MODELS
Total saving is the sum of government,
business, and private saving. In developing countries,
most saving is accumulated by private households and
the unincorporated business sector. Government
saving has not grown much in the developing countries
and corporate saving is relatively small.
Virtually all research in this area has been devoted to
the study of private or household saving. There have
been two major developments in the theory of personal
consumption and saving since Irving Fisher (1930) and
Frank Ramsay (1930) set up saving as a choice
between present and future consumption in the 1920s.
In the Keynesian model, saving is primarily a function
of current income, and borrowing to sustain income is
not considered. This borrowing constraint is relaxed in
income smoothing models.
Here are some of the models of savings which we are
going to consider for this topic:
● Keynesian and Income Constrained Models
These models start with the simple observation
that consumption may depend upon current
income (the centerpiece of the Keynes’ [1936] The
General Theory). In the simple models of Consumption
behaviour presented at the beginning of an economics
course, the consumption function is presented as a
linear function of income while saving forms the
residual: C = a + bY and Y = C + S, so Y- S = a +
bY and S = -a + (1 – b)Y, where S is also a linear
function of income.
This model was overtaken by more plausible theories
in the 1960s and 1970s that allow for consumption and
income smoothing over time-that is, borrowing to
smooth consumption so that it does not depend
completely on the current level of
income. Nevertheless, the simple Keynesian model
featuring the importance of present income has made
a comeback with the work of Deaton (1989, 1991,
1992) and Hall (1978). Hall argues that expected future
income is subject to random changes so that current
income is the only reliable predictor of current
consumption and saving. Alternatively, income
smoothing does not occur or is weak and this vitiates
the life cycle model.
There are several possible reasons for this:
1. Income smoothing is not possible because of
borrowing constraints and imperfect capital markets.
2. Income smoothing is not applicable since many
generations live together, weakening the need for
individuals to save.
3. Future incomes are uncertain so it is difficult to
plan over a lifetime. This is particularly true when
individuals are self-employed or depend upon
agriculture harvests. It has also been shown that the
poor usually have a very short time horizon and a high
discount rate. This is why it is difficult for them
to break out of the cycle of poverty. Thus, in these
models people do not optimize their potential over
their life cycle. Rather, consumption is more
closely related to current income.
● Income Smoothing Models: The Permanent
Income and Life Cycle Hypotheses
These are models that allow for consumption
smoothing over some time horizon without constraint.
Families can borrow and save at will in order to smooth
their consumption patterns to compensate for
fluctuations in income. The time horizon in these
models can either be a person’s lifetime or a longer
(sometimes infinite) time horizon. The permanent
income hypothesis (PIH) of Friedman (1957) and, Hall
(1978) assumes an infinite lifetime horizon.
In the Friedman version, consumption is based on
permanent income (YP), and all transitory income (YT)
is saved: C = a + b YP where YP + YT = Y.
Permanent income is determined as a declining
weighted average of past income, for example, YP(t) =
b (Y(t -1)+b2 Y(t 1)+ ......
In the life cycle hypothesis (LCH), Modigliani (1970)
assumes a finite horizon (lifetime). There is a time
profile of saving and consumption that leaves the
individual either with no saving at death, of a
predetermined bequest at death. This model is
characterized by a hump in the saving function during
the maximum earning years.
It is important to know which of these competing
theories is most appropriate for the developing
countries. Saving is a key variable in determining
growth, as we have seen earlier. How saving behaviour
is conditioned is also significant in order to explore the
implications for macroeconomic policy and the impact
of changing government policies. Much of the literature
on the developing countries deals with how these
models can be used and tested. The aim of this
chapter, however, is to summarize the impact of
different variables on saving behaviour for developing
countries, rather than delve deeper into alternative
tests of these models. In either income-smoothing
models or in income-constrained models, there are
several broad categories of variables that can have an
impact on savings. Before discussing these results, we
will first look at the realism of the unconstrained
income-smoothing models, such as the pure LCH or
PIH.
Evidence suggests that the LCH/PIH model does not
strictly apply to the aggregate of all consumers, Many
consumers, even in developed countries, are affected
by liquidity constraints. As a result, some consumers
will follow LCH/PIH but a large proportion-as much as
half, according to Campbell and Mankiw’s (1989)
estimate for the United States-will consume a constant
proportion of income. Thus, it may be useful to enter a
variable which serves as a measure of financial
constraints on borrowing, or alternatively on financial
market liberalization. But this is getting ahead of our
story.
Determinants of Savings
REAL INTEREST RATES Higher real interest
rates stimulate saving by offering higher financial
returns for abstaining from consumption through the
substitution effect. On the other hand, higher interest
rates result in more income for creditors and this
stimulates consumption through the income effect
Furthermore, a negative income effect could manifest
as a decline in pension contributions when interest
rates rise. Most of the empirical evidence shows a
limited interest rate effect. What may be more relevant
is the stability and reliability of an interest rate regime.
This would be the case if inflation is low and there are
no unanticipated increases in prices which could push
interest rates down sharply. Such a reliable interest
rate environment would provide a positive inducement
to savers. Given that financial liberalization may have
changed interest rate effects, the lack of an interest
rate is not surprising. Financial liberalization can boost
saving by providing more institutional opportunities for
saving at lower costs. McKinnon (1973) argues this
point strongly. Financial liberalization may also remove
constraints to saving by allowing for more borrowing
opportunities. This would tend to depress saving rates.
In cases where financial liberalization has been
undertaken, both of these effects have been observed,
although the liberalization effects on raising saving is
weaker than the evidence that access to credit
depresses saving and increases consumption.
ROLE OF THE GOVERNMENT If the
government raises taxes (increases government
saving), incomes will decline and private saving can
also be expected to diminish, other things being equal.
Will the offset be complete? The evidence seems to
suggest that it is not (Ricardian equivalence is
rejected). Most research on the developing countries
(Masson et al., 1995, 1998; and Westcott, 1995),
suggests that about half of the change is reflected in a
decrease in private saving. The effects on saving will
depend upon whether the change in the fiscal deficit
occurs through a change in the tax rate or in the rate of
government spending. Increased government
spending may lower the resources available to the
private sector and hence, have a negative effect on
private saving independent of its impact on the deficit
There is some evidence that governments in large
developing countries, as proxied by the share of
government expenditures in gross national product
(GNP), may have a negative effect on private saving (
Masson et al., 1995; and Harrigan, 1998). This could
result from the crowding out of private investment (and
saving) by the public sector. Government policies
toward saving can also have an impact on the private
saving rate. Public pensions can lower private saving
because they may substitute for private pensions.
Feldstein (1995) has argued that a public system
based on pay-as-you-go instead of on actuarial
principles would lower national saving because
pensions would be paid for by the still unborn children
who could not adjust their saving behaviour. There
would also not be a full offset from the working
population because Ricardian equivalence would not
hold ( Harrigan, 1998).
GROWTH IN INCOME If workers believe that
a change in income is permanent, in a LCH/PIH world,
consumption would be adjusted upward accordingly
and the current saving rate could fall. On the other
hand, those who do not earn from current income but
from accumulated assets, such as those who are
retired, might dissave at a lower rate as a result of the
wealth effect of more rapid income growth. The
increase in income could also have an impact on the
rate of return on capital and hence the real interest rate.
Whatever the theoretical significance of growth in
income, empirical tests by a number of researchers
have found that there is a strong relationship between
income growth and saving. This evidence for
developing countries is strongly affected by the results
for those Asian countries that have had high-income
growth and high saving rates. This has important
implications for countries like Japan, where the growth
rate has fallen significantly. However, saving rates in
Japan have not fallen as expected.
POPULATION AGE STRUCTURE LCH
implies that the age structure plays an important role in
saving behaviour. The saving rate is expected to
decline as the population ages. A country with a very
low dependency rate (large working population as a
ratio of total population) can be expected to have a
higher saving rate in an LCH model. The young and the
retired are usually dissavers. Several cross section
studies have confirmed this result (Masson et al.1995).
However, these macroeconomic results across
countries are in conflict with some microeconomic
studies which show that age-consumption profiles do
not differ enough to explain why aggregate
consumption should be affected by demographic
factors. The LCH assumption that lifetime income is all
“used up” at the moment of death, may also be
erroneous. Since the time of death is uncertain,
bequests may not be planned. Alternatively, bequests
may be part of a bargain with children in exchange for
taking care of their parents. An alternate model, called
the dynasty model, postulates that individuals build
fortunes and save in order to make bequests to family
members. There is the, perhaps apocryphal, story that
Henry Ford maintained an MPC of 0.5 throughout his
lifetime. In a household where there are several
generations living together, there is no individual
saving structure since assets are held in common. In
this setting, the age structure of the population should
not have any effect on saving.
LEVEL OF INCOME If LCH and PIH are
correct, then saving should not be related to current
income. However, several researchers such that of
Hall (1978) have found that current income is an
important explanatory variable. These results lend
partial support to the idea that there are liquidity
constraints and/or that income smoothing may be in
response to short-run income fluctuations.
It also suggests that precautionary saving motives are
stronger than life-cycle effects in the developing
countries.
TERMS OF TRADE The terms of trade effect
works through an unanticipated and transitory increase
in income by an improved trade balance. Since
changes in the terms of trade are usually viewed as
temporary, they would be incorporated into the
LCH/PIH framework as transitory, with a strong
positive effect on saving. The empirical literature finds
this to be generally supported (Masson et al., 1995;
and Ostry and Reinhart, 1992).
An unexpected improvement in the terms of trade can
have a positive effect on the saving rate because it
represents a windfall gain in income and, according to
the life cycle and permanent income models, would be
saved (Obstfeld, 1982). The terms of trade effect can
be substantial if the shift is large. For example, the oil
shocks of the 1970s represented a sharp shift in the
terms of trade in favour of oil exporters and a similar
increase in the rate of world saving as these funds
could not be spent as fast as they accumulated.
 DEGREE OF FINANCIAL LIBERALIZATION
AND STABILITY A general rule of thumb regarding
saving would be that financial stability and liberalization
are positively related to the rate of private saving, other
things being equal. A predictable and stable financial
environment that offers a range of financial instruments
can be expected to call forth a higher level of saving
from the private sector than a volatile and capricious
financial and economic environment. However, an
alternative view would be that increased volatility could
lead to a greater precautionary motive for saving.
Theory gives no guidance apart from the recognition
that a more liberal environment should lead to higher
saving rates.
DETERMINANTS OF SAVING IN DEVELOPING
COUNTRIES AND IN ASIA
Figure 8.1 shows the level of gross domestic
saving rates as percentages of GDP in the world.
Developing countries, such as those in South Asia and
Latin America, generally saved up to approximately 20-
25 percent of GDP between the 1960s and 2000s.
However, they lagged behind those of East Asia. The
level of saving in East Asia has surpassed that of the
world since the early 1970s, with a saving rate of about
47 percent of GDP in 2006. Saving rates in South Asia
has been rapidly increasing since 2001 and is currently
at 35 percent of GDP. However, Higgins (1998) states
that after 2010, the greying population in the East Asian
countries (such as Singapore and Hong Kong) would
have a substantially reduced number of working-age
adults in the workforce which would adversely impact
upon their level of saving in the future. Hence, he
concludes that in the future, higher levels of saving
would most likely come from developing countries,
such as South Asia and Latin America, where a high
proportion of the population would be in the labor force
or rapidly approaching working age.
Figure 8.1
Source: World Bank, World Development
Indicators Online.
● Determinants of Saving in Developing
Countries
The Masson et al. (1995) study reports a number
of regressions, some of which are shown in Table 8.1.
The results show that the rate of growth of GDP, the
terms of trade, per-capita income, total wealth, the
dependency ratio, and the current-account
surplus/GDP are all significant explanatory variables
for a large sample of developing countries over a long
period. Per-capita income enters in a non-linear
fashion, with the square of the variable also being
significant. A negative sign indicates a diminishing
effect as the saving rate increases. All the variables
have the expected signs, as discussed in the previous
section. Two variables not discussed above but
included in the regression are the current-account
surplus/GDP ratio (equal to minus foreign saving) and
wealth. The current-account surplus/GDP variable was
added to reflect the impact of foreign savings/transfers
on domestic saving. The sign is correct and suggests
that an increase in foreign saying equal to 1 percent of
GDP reduces the national saving rate by about 0.4
percentage points. The sign of the wealth variable is
also positive, suggesting that saving rates are higher
for the wealthy.
Table 8.1
● Determinants of Saving in Asia
For Asia, there is evidence imbedded in the study
by Masson et al. for high and medium-income
developing countries (reported in Table 8.1) that
suggests that the variables explaining saving in these
countries are similar to those that explain saving
behavior in all developing countries. Apart from Nepal,
India, Bangladesh, and Myanmar, all the countries in
developing Asia are in the high and medium income
countries, which had similar patterns of significance for
the explanatory variables as the entire group of
countries reported above. In addition, scatter plots of
bivariate relationships between saving and some of the
most important explanatory variables, such as income
growth, foreign saving, and the dependency ratio,
confirm the importance of these variables in explaining
variations in saving in Asia. Furthermore, individual
country studies for Korea (Dowling, 1984), the
Philippines (Nam, 1989), and Southeast Asia
(Harrigan, 1998) give support for the importance of
income and demographic variables. A careful review of
this and other evidence led Harrigan (1998, p. 42) to
conclude that:
“A trinity of fast growth, fiscal rectitude and
slowing population growth have been
associated with high savings in Asia. Where
one or more of these ingredients have been
missing, savings have suffered.”
These conclusions are supported by an econometric
study of discretionary private saving behavior in
Southeast Asia using an error correction model for the
period 1971 to 1991. Harrigan (1998) concludes that
GNP growth has a positive effect on saving in both the
short and long run. Investigation of the possible
simultaneity effect caused by the feedback of saving on
investment and income suggests that these effects are
weak. The terms of trade effect is positive and this
result is consistent with the economic theory discussed
earlier, and also with results from other sets of
developing and industrial countries. With respect to
dependency, young age dependency (the proportion of
the population 15 years and under) has a very strong
impact on the saving rate, while the proportion over 65
years does not. This asymmetry may be because the
burden of the elderly has not changed as much as the
sharp decline in the youth dependency in the latter
years of the sample period. An interesting facet of the
Harrigan model, which has not been explored
elsewhere, is that as the share of agriculture to total
income contracted, there has been a negative effect on
the level of discretionary private saving. This could be
because agricultural income has a wider variance than
non-farm income and hence a higher precautionary
motive to save.
INTRODUCTION TO THE FINANCIAL SYSTEM
The financial system is an integral component
of modern economies. In most Asian countries,
commercial banks constitute the primary component of
the financial system. However, informal financial
institutions also play an important role. Furthermore, in
the last decade or so, other financial institutions,
including insurance companies and pension funds, as
well as stock and bond markets, have gained greater
importance. Before the Asian financial crisis, a number
of weaknesses in the banking system were noted,
which eventually, along with other developments in
international trade and finance, led to the crisis itself.
The aim of this topic is threefold. First, the banking
systems and credit markets are discussed generally
and briefly, along with the topics of financial repression
and liberalization. This is followed by a summary of the
experience of developing countries in general, and
Asia in particular. A section on the Asian financial crisis
highlights the shortcomings in the institutional structure
of the bank and credit system with reference to this
crisis. A number of developments in financial policy and
regulation following the financial crisis are discussed in
the next section. The chapter concludes with a
discussion on informal finance and how it relates to the
formal sector and monetary policy.
BANKING AND THE FINANCIAL SYSTEM
The banking and financial systems in the
developing economies in Asia evolved from systems
that were in place during the colonial period. In South
Asia, Taiwan, Malaysia, Hong Kong, and Singapore
the British system was adopted, while in East Asia, the
Japanese model was adopted in Korea. In cases such
as Thailand and China, which were not colonized to
any significant extent (some coastal cities, Such as
Hong Kong, did have significant colonial influence), the
financial systems were borrowed from the industrial
countries.
In most cases, these financial systems were dominated
by the banking system and commercial banks. The
government in turn controlled the banking systems. By
and large, commercial banks were either owned or
controlled by the central bank. In South Asia, this was
a persistent pattern of ownership and control that has
changed only slowly in the past decade or so. In East
and Southeast Asia with the exception of Hong Kong,
which has been dominated by private commercial
banks from its inception as a trading center by the
British in the nineteenth century, there has been a slow
devolution of control and ownership by the
government.
Nevertheless, by the early 1970s, the region as a whole
could be characterized by the widespread presence of
financial repression. Financial repression is a situation,
first described fully by Shaw (1973) and McKinnon
(1973) in the early 1970s, where government taxes and
subsidies distort the domestic capital market
(compared with a free and competitive system where
private banks are supervised by a central bank) by
imposing interest rate restrictions and high reserve
requirements. At the same time, there are compulsory
credit allocations to some sectors and the lack of credit
to others. As a result, loans extended by banks were
not thoroughly analyzed in terms of risk or project
viability. Competition among banks was also limited,
particularly as foreign banks were not allowed to enter
the market or where their presence was highly
regulated. In these cases, there were few incentives for
improving bank efficiency. In a study of the
Organization for Economic Cooperation and
Development (OECD) countries, for example, Terrell
(1986) concludes that the exclusion of foreign banks
reduces competition, making domestic banks more
profitable but less efficient. Since requirements were
high already, excess funds were often parked in
government securities rather than used to seek out
high-yielding, 10w-risk investments in the private
sector. Furthermore, in countries where foreign banks
were allowed to compete vigorously, such as
Singapore and Hong Kong, there was much greater
efficiency and lower profit margins.
This kind of banking system evolved during a time
when development thinking believed that the
government had to play a strong role in mobilizing and
allocating credit to facilitate investment and promote
economic development. There was a widespread belief
that the private sector was too weak to mobilize
sufficient resources and that the banking system was
to be used as an instrument by the government to step
in. Interest rates had to be controlled and some sectors
subsidized further to keep the costs of investments low.
Since the private sector’s role in saving and
investments were minimized, the impact of low (and
sometimes negative real) interest rates on savings of
the private sector was not systematically considered.
A. Financial Repression
These various controls and schedules
interacted, resulting in a financial system that did not
allocate credit to the public in an efficient manner, and
the banking sector played a smaller role than it could
have in a more competitive and free environment. Such
“repressed” financial systems were characterized by
low or negative real interest rates and a low and
sometimes falling ratio of monetary assets to
GDP/GNP. In a repressed system, the government
usually plays a dominant role in controlling the banking
system by imposing these kinds of controls, using
banks to serve as the instruments for allocating credit
to key selected sectors. Often, specialized banks were
created to address the needs of particular sectors.
Rural banks were often created for this purpose in the
early stages of development and were complemented
by banks focusing on key industries later in the
development process.
At the same time, credit to other potential borrowers
was lacking. As a result, informal or “kerb” markets
developed outside the formal financial system to
mobilize and direct credit to those sectors not
effectively serviced by the formal financial and banking
system. The overall impact of these devel0Pments was
a fragmented banking system where the organized
banking system serviced only a small Part of the total
capital market while informal finance emerged to serve
the needs of other borrowers. Capital was allocated
inefficiently within the banking system since potential
borrowers were not properly screened, competition
within the banking system was limited, and loans were
extended based on preferential credit allocations and
not on economic feasibility studies or project
evaluation. Interest rates did not reflect the interaction
of the supply of and demand for funds. Neither did they
reflect the riskiness of projects. Instead, interest rates
were determined by flat based on the perceived
importance of the sector to which the funds were being
allocated-the more important and critical the sector, the
lower the rate of interest. Self-finance within
enterprises was also impaired when real interest rates
were low or negative as it became difficult to save for
needed projects. Finally, financial deepening outside
the banking system was difficult in the face of financial
repression. This was true not only because it was
discouraged by the government and the central bank,
but also because of the lack of liquidity and the
arbitrariness of government policy, and the potential or
actual lack of financial stability.
B. Financial Liberalization
How then were the “miracle” economies of East
and Southeast Asia able to develop such dynamic
economies? In parts of East Asia, particularly in Hong
Kong and to a lesser extent in Singapore, the banking
system was not encumbered by too many regulations
and restrictions. In. Korea and Taiwan, there was clear
evidence of financial repression, but the policies of the
government did supply cheap finance to support key
sectors in the industrialization effort. Thus, in some
sense, financial repression was not as great a
handicap in East Asia as it was in South Asia, where
the other policies of openness, competitiveness in
exports, and more liberal industrial policies were not
followed. In China, after opening to the rest of the world
in the 1980s, financial incentives were used to develop
the town and village enterprises as foreign investment
from Taiwan and Hong Kong was allowed to enter.
However, the continued support of inefficient state-
owned enterprises (SOEs) drained resources for many
years. Even now, the budget support for these
enterprises continues to be a challenge. In Southeast
Asia, financial repression was not as extensive as in
South Asia, and more private-sector involvement was
permitted. As industrialization proceeded, financial
liberalization continued and strengthened, although
elements of the old system remained, as we shall see
when we look into the financial crisis of 1997.
Very simply, financial liberalization is designed to
remove all the restrictions that characterize financial
repression. These include the lowering of reserve
requirements, freeing up interest rates, and allowing
them to respond to market forces. Managed credit
allocations to key sectors should be reduced or
eliminated, and loan officers should be required to
evaluate potential borrowers on the merits of the
project and not to give loans indiscriminately based on
other noneconomic criteria. Competitive forces should
be allowed to operate in the banking system to improve
economic efficiency through the relaxation of entry
requirements, both domestically and for international
banks. Together with these measures, price levels
should be effectively controlled to keep inflation to a
minimum. In this way, positive real interest rates can
be easily maintained. Given the strong theoretical
backing of Shaw (1973) and McKinnon (1973), many
countries undertook financial liberalization.
C. Asian Experience of Financial Liberalization
In the 1960s and 1970s, the commercial
banking system was tightly controlled by the
government in almost all the Asian countries. Banks
were owned and operated by the government and it
was believed that one purpose of the banking system
was to help further the government’s objectives of
making loans to subsidized sectors through a process
of direct credits. It was believed that private banks
would not make such loans. Furthermore, interest rates
were controlled and credit allocation schemes were
used' Banks were required to hold government debt
that cut the cost of borrowing by the government.
Prudential regulations were largely neglected since the
government controlled the banking system. Bank and
development finance institutions (DFIs) were the main
financial intermediaries. DFIs were introduced to
further allocate credit to particular sectors, and they
were given appropriate names such as Agriculture
Development Bank or Industrial Development Bank.
Organized markets for private equities and bonds were
either non-existent or very thin, and few licenses were
granted for other non-financial intermediaries such as
insurance companies or pension funds. The quality of
loan portfolios was not an important consideration,
being outweighed by the need to direct credit to
different sectors at subsidized rates. The only
exceptions to these generalizations about banking
during this period were Hong Kong and (later)
Singapore. . .
In the 1980s and early 1990s, financial liberalization
began in the NIEs and in Southeast Asia. More
competition was permitted as regulations on private
and foreign banking were relaxed. Interest rates were
deregulated to a large extent while directed credit and
requirements to hold large amounts of government
securities were reduced. A modicum of independence
was also evident as they became more autonomous
and escaped the grip of the Treasury. Some prudential
regulations were introduced, including auditing and
oversight functions.
In South Asia, the pace of reform, with the possible
exception of Sri Lanka, was slower as fewer Changes
were implemented and the structure of the financial
system remained repressed. A country-by/ country
summary of regulations in the early to mid-1990s is
displayed in Table 8.2
 Table 8.2
D. Measures of Financial Repression
Nevertheless, substantial evidence of financial
repression remained in several countries. This is
shown by some aggregate measures of financial
deepening. One such widely used measure of financial
repression and financial liberalization is the ratio of
money plus quasi money (M2) to GDP/GNP. The ratio
rises with liberalization and falls with financial
repression. A comparison of these ratios for Asia in the
last thirty years shows that this ratio has been
increasing rapidly in East and Southeast Asia (see
Table 8.3).
Table 8.3
The cases of Malaysia and Thailand are particularly
noteworthy. From fairly low levels in 1970 not much
higher than ratios, in South Asia), the ratio rose to more
than 1 by the end of the 1990s. In Thailand, the
commercial banking system was predominantly private
and extensive liberalization took place in the 1980s.
Compulsory credit to priority sectors was reduced and
interest rates were largely deregulated in the early
1990s. Exchange controls were also relaxed and the
reserve ratio was reduced to 7 percent in 1991. A
facility (Bangkok International Banking Facility) was
introduced in the mid1990s to help the domestic and
foreign banks to borrow in overseas markets. Later in
the decade, these liberalization measures, which were
adopted without the accompanying prudential controls
and safeguards, helped the financial system to
participate in a stock and property market bubble that
resulted in a run on the currency and the beginning of
the financial crisis.
Hong Kong and Singapore, particularly the former, had
high ratios that increased further over the period.
Writing in 1988, McKinnon characterized this ratio in
the rapidly growing economies of Japan, Germany,
Taiwan, and Singapore as having a value of 0.75 (75
percent) or more. By 1999, Malaysia, Thailand, and
Singapore had joined Japan, Taiwan (not shown in
Table 8.3), and Hong Kong in this club. Taiwan began
banking reform in the 1980s as foreign exchange
controls were lifted, interest rates decontrolled, and
new private banks were authorized to do business.
However, tough restrictions were placed on the capital
required for these new banks. There were no directed
credits either as the government adopted a hands-off
policy with regard to bank-lending requirements. Korea
(and the United States, Which has a ratio unchanged
from the 1970s) continues to rely on foreign loans to a
greater extent than the other countries and thus, its
ratio has not increased as much. Furthermore, until
recently it pursued? Vigorous policy of directed credit,
and consumers and other borrowers not targeted had
to rely on the “kerb” market. While this situation has
changed in recent years, the financial ratios still reflect
these earlier practices.
In South Asia, there has been some progress in
financial liberalization in recent years but the M2/GDP
ratio has remained lower than in the other countries in
the Asian region. This trend is particularly noticeable in
Sri Lanka and Pakistan. In the latter economy, the ratio
has remained unchanged after thirty years. The
banking system remains dominated by government-
owned institutions, as private banks control 1683 that
20 percent of all assets. There has been some interest
rate deregulation although reserve requirements
remain high at around 30 percent, but progress in
further deregulation and reduction in the scope of the
government in directing credit has been slow.
In India, the MZ/GDP ratio has grown more rapidly than
in other South Asian countries. However, the financial
system still shows signs of financial repression. Banks
are publicly controlled and interest rate caps remain in
place. Bank licensing was eased in 1992 and some
measures have been taken to reduce reserve
requirement and the scope of directed credit. However,
more needs to be done, including reform of bank
supervision and finance institutions that have high
levels of nonperforming loans Indonesia also exhibits
signs of continued financial repression as the M2/GDP
ratio increased from a very low level to a more
moderate 0.36 by 1999. Nevertheless, these figures
belie substantial liberalization of the financial system
that began in the 19803 with deregulation and the
introduction of private banks, lowering of reserve
requirements, deregulation of interest rates, and
reductions in the scope of directed credit. However, the
liberalization measures were not accompanied by
tighter prudential controls and many of the practices
that existed before liberalization were continued. This
led to bad loans and growing weakness of bank
portfolios as the bubble of the mid 1990s ballooned.
In the Philippines, banks were also liberalized in the
1980s. As a result, the banking system is basically in
the hands of the private sector. There are only two
development banks channelling funds to needy
enterprises in the rural areas and to some urban
industries. Foreign ownership is allowed up to 40
percent, and no branches are allowed to be set up by
foreign banks outside of Manila. Interest rates are not
regulated and reserve requirements are low. There are
some directed credit allocations but they apply mainly
to rural banks. As a result of these reforms and the
difficulties experienced in the 1970s, the financial
sector in the Philippines was not highly leveraged in the
early and mid-1990s and was therefore able to
withstand the financial crisis without having to
introduce an asset management company to deal with
bank loans. Nevertheless, the financial system-has
been weakened by the lack of a good prudential and
regulatory system and the continued presence of
corruption and crony Capitalism.
In the case of China, where we have data only from
1979, the ratio has fallen slightly over twenty Years.
There are several factors working here. First, financial
repression still exists as state banks dominate and
funds are channelled from the banking system to state-
owned enterprises. Interest rates remain controlled
and there is a lack of competition. Secondly, much of
the finance for the vibrant private sector in the southern
coastal region has come from foreign sources. Thirdly,
the growth of the local stock market, also financed in
part by foreign funds inflow, has been responsible for
some growth in total liquidity of the financial system.
The following is a supplemental reading regarding the
Financial Crisis and the Global Financial Crisis of
2008/2009 and Its Impact on Asian Financial Markets.
THE FINANCIAL CRISIS OF 1997
The Asian crisis had three main components.
First, because banks believed implicitly or had been
assured that they would be bailed out in case of a
crisis, a strong moral hazard developed as commercial
banks made more and more risky loans and the
financial bubble grew bigger. This resulted in both a
land and stock market boom as prices were bid up and
available supply remained limited. Stock markets
crashed in several countries prior to the crisis but this
did not arrest the financial bubble. It undermined the
economy further when stock prices fell even further
after the crisis began. Banks were not only guilty of
making imprudent loans; but they were also not used
to due diligence in assessing the credit risks of
borrowers, and this failure became even more evident
as banks made more risky loans
As the financial crisis unfolded, the weaknesses in the
five crisis countries were exacerbated by the currency
depreciation and the build-up of nonperforming loans
of companies that had large outstanding external
liabilities that they were unable to service.
After the crisis, all the affected countries were able to
slowly recover and deal with their financial sector
weaknesses. Many of the weaknesses identified prior
to the crisis that were outlined in the previous section
continue and need to be addressed. Briefly, they
include the need to:
● introduce better processes to identify worthy
borrowers and make greater use of loan collateral
● further deregulate of financial transactions.
● introduce a greater degree of prudential regulation
of banks.
● introduce more competition and reduce restrictions
on licensing and entry
● Support the development of new markets,
particularly for new financial assets that will allow
investors to hedge their investments, including
forward and futures markets
● continue to privatize state banks.
● improve lender recourse, including the legal
seizure of assets.
● improve accounting and auditing practices.
As part of the restructuring efforts following the
financial crisis, insolvent financial institutions have
been closed, merged, or recapitalized to varying
degrees. Corporate debt problems have also been
addressed through corporate and debt restructuring.
Generally, asset management companies (AMCs)
were created to facilitate debt restructuring. These
AMCs took the bad debts off the hands of the banks
and worked to collect and write down these debts, often
with the help of government financial support. By taking
these nonperforming loans (NPLs) off the balance
sheets of the banking system, the way was cleared for
banks to begin to relend after the crisis.
GLOBAL FINANCIAL CRISIS OF 2008/2009 AND
ITS IMPACT ON ASIAN FINANCIAL MARKETS
The real impact of lower export demand and
the outflow of financial capital from the Asian region
were explored. In this section, we look a little more
closely at the implications of the global financial crisis
on the Asian financial markets. As Chapter 4 indicated,
the Asian financial markets were relatively stable when
the global financial crisis began in 2008. Many reforms
that had been suggested following the 1997 Asian
financial crisis had been adopted and bank balance
sheets were in better shape. The size and incidence of
NPLs had also been reduced. The practice of short-
term overseas borrowing to refinance longer-term local
projects at higher interest rates was also curtailed.
Exchange rates, while still loosely tied to the US dollar,
were also more flexible than they were before the 1997
financial crisis. Banks and other financial institutions
were well aware of the risks of assuming a secure
dollar link when making overseas borrowing
commitments. Despite these changes in regulations
and banking practices, the global economic crisis that
began in late 2008 and continued through the early
months of 2009 has created additional financial stress
on Asian financial systems. Stock markets have
weakened considerably as the industrial sectors have
suffered from lower levels of production and
manufactured exports. Foreign direct investment has
been less volatile than short-term capital movements
and is not expected to fall dramatically in 2009.
Furthermore, government stimulus packages are
expected to help shore up private investment. For
example, Singapore has announced a
US135billionstimuluspackagedesignedtopreservejobs,
stimulatebanklending,andenhanceinternationalCompe
titivenessthroughtaxreliefandgrantstobusinesses.Anot
herUS1.7 billion has been allocated to the upgrading of
infrastructure and health and educational facilities.
China also has recently taken steps to shore up its
economy by announcing a US$586 billion
infrastructure investment program to be implemented
over 2009 and 2010 (amounting to about 6 percent of
GDP). The projects will include low-income housing,
electricity, water, rural infrastructure, environmental
protection, and technological innovation. This package
is intended to boost confidence, as well as provide jobs
and additional spending to offset the anticipated
slowdown in exports. Other countries in the region are
also implementing stimulus measures. For these
reasons, while there are reports of increases in NPLs
in a few countries (such as Korea and Vietnam), it is
unlikely that the region will suffer from the same
financial sector difficulties that it experienced during
the Asian financial crisis a decade ago.
*** END of LESSON ***
Introduction: POPULATION
World population has followed an S-shaped
pattern of growth over time. In antiquity, the rate of
population growth was very slow. Birth and death rates
were both very high. As death rates fell with the
development of modern medicine, population growth
accelerated in the eighteenth and nineteenth centuries
and continued into the twentieth and now, the twenty-
first century. Asia’s population grew very slowly in the
nineteenth century-less than 0.5 percent-but began to
accelerate in the twentieth century-to 1 percent per
year between 1900 and 1950, and 2 percent during the
second half of the twentieth century (Asian
Development Bank, 2002). The rate of population
growth in developed countries fell from 1.3 percent per
year in early 1960 to about 0.7 percent per annum by
2000, while that for the developing countries
decreased slightly, from 2.3 percent to about 1.8
percent over a similar period. This suggests that,
compared with the immediate post-World War II period,
developed countries now contribute very little to
population growth.
information alongside the per-capita gross national
income (GNI) and the countries are grouped according
to their regional location. It is immediately obvious that
poorer countries tend to have higher population growth
rates. In the case of the African countries, all have
relatively high birth and death rates. The highest
population growth rate is registered for Uganda, and
this is because it has the highest birth rate in the group,
while its death rate is relatively lower than those of the
other countries in the region. Zambia, on the other
hand, registered the lowest population growth rate in
the set because its birth rate is on the low end of the
scale, while its death rate is the second-highest in the
group. It is thus clear that both birth and death rates
jointly determine the growth rate of the population.
Table 9.1

In Asia, on the other hand, population growth rates

were among the highest in the world during the period
since World War 11. Between 1950 and 1990, the total
population of Asia (18 countries) increased by 125
percent, compared with only 112 percent growth for the
world population (Sanderson and Tan, 1995).

Population is always a subject of interest to analysts of

economic growth. In the early days, many economists,
led by Thomas Malthus (1798), warned of the gloomy
consequences of an ever-increasing Population.
These included hunger, famine, and poverty as
population growth consumed any addition in income
and wealth. "Ibis kept income and standards of living at
subsistence levels and in a low-level poverty trap.

SOME BASIC CONCEPTS

To be able to embark on a meaningful discussion

of population and its role in economic development, it
is necessary to understand a number of basic concepts
and terms. The concepts discussed here are common
tools to help us undertake useful analysis of population
issues.

● Birth and Death Rates

Birth and death rates are two fundamental
concepts necessary to understand rates refer to the
number of births per thousand people, while death rate
deaths per thousand people. A birth rate of 26 for
Bangladesh in 2005 means that there were 26 new
born babies per thousand people during that year. In
the same way, a death rate of 8 implies that an average
of 8 deaths occurred per thousand people in
Bangladesh for that year

The population growth rate is the net addition to the

population over a certain time period. This measure is
likewise expressed as the number of additional
individuals per thousand people and can be derived
simply as the birth rate minus the death rate. In our
example, the population growth rate is therefore 18 per
thousand people. It is, however, customary to give this
statistic in percentage, and thus the population growth
rate for Bangladesh is often presented as 1.8 percent.
Table 9.1 shows birth, death and population growth
rates for a diverse set of countries. It presents this
Source: Data from World Bank, World Development
Indicators Online (2008)
● Population Age Distribution
Singular measures of population change, such as
birth and death rates, mask a lot of other useful
information that are of significant interest and
relevance to those who study population dynamics. To
make meaningful analysis, it is also important to know
the age distribution of the population. This is provided
when the population shares of each age group is given.
Such information can help us distinguish between two
countries with high population growth rates, but where
one is a young population that has a large proportion
of their members in the childbearing ages and thus has
a high birth rate, while the other is a very mature
population where high death rates are registered for
the older age groups.
The age distribution of the population in the various
regions of the world is given in Table 9.2. We can see
from here that about 2 in every 5 persons in Africa are
under 15 years old, while only 6 in every 100 persons
there are aged 60 or over. In Europe, meanwhile, there
are less than 2 children for every 10 people, while 1 in
every 4 persons is aged 60 or older. The proportions in
North America are a little less extreme than those in
Europe, but the pattern is clear. More developed
economies tend to have both a lower proportion of the
population under 15 years old, and a greater proportion
of those in the 60 and older age group. Less developed
economies, on the other hand, tend to have
significantly younger populations and. thus higher
dependency ratios. The young populations in Africa,
Asia, and Latin America will push population growth
rates further up in the near future when this generation
of kids reaches childbearing age, and this can be a
problem. A low dependency ratio is perceived as more
desirable for economic growth. Having a larger
proportion of workers in the population implies greater
ability to support those not working (children in
particular) and therefore less drag on the economy.
Additionally, national investments in education and
health can have greater impact per person if the
dependent population is relatively small.
Table 9.2
Source: United Nations Population Reference Bureau,
World Population Data Sheet (2007)
As it happens, the working-age population moves into
retirement over time and eventually puts an additional
burden on the rest of society. The size of this burden
will depend to a large extent on whether they have
saved enough during their working years to support
themselves, or whether the state will have to provide a
subsidy. Aging populations are receiving greater
attention in policy forums in Japan and generally, within
the Organization for Economic Cooperation and
Development (OECD). The challenge is reinforced by
continued declines in birth rates and extension of life
expectancy in these developed countries.
On a more micro scale, the age structure within
populations also provide important insights into growth,
employment, and other welfare issues affecting
particular economies. Table 9.3 presents an
international comparison of individual country
population distribution broken down by age.
Differences in the age structure have mixed effects on
the percentage of the labor force to be employed.
Growth in an economy would be more likely to occur if
a vast majority of the population are in the working-age
group (15-64 years old) and are actually employed.
This means that the dependency ratio is low, and that
a significant proportion of the population is contributing
to economic production. In this case, national income
can be used more effectively to support children in
education and health until they get to working age;
dependent retirees can also be provided with more
generous pensions and other allowances as they
advance in ages.
A rapidly growing population is normally characterized
by having a high proportion of persons under 15 years
old. In the table, this is exemplified by India, Pakistan,
and the Philippines-countries where those aged under
15 years take up more than a third of the population
share. This youth effect, as it is normally called, creates
a large supply of people too young to work and is
typical of developing economies. On the other hand, a
slowly growing population is characterized by a large
proportion of people who have reached retirement
(usually 65 years old). This retirement effect is typical
of developed countries where there are high life
expectancy rates. In the table, this effect is largest in
Germany, Italy, and Japan, with more than 25 percent
of their populations aged 60 or older. It is nonetheless
possible for countries to experience both youth and
retirement effects simultaneously as better public-
health policies reduce death rates while birth rates
remain high. Which effect dominates?
Rapid population growth also affects the percentage
available to be employed through the female
availability effect. With a slower growth rate and fewer
children to care for, more women are available to join
the labor force; Both the dominance of the youth effect
(over the retirement effect) and the female availability
effect suggest that rapid population growth reduces the
percentage of the population in the labor force which,
in turn, has a depressing effect on economic growth per
capita.
● Other Demographic Measures
The total fertility rate (TFR) is the total number of
children a woman is expected to have over her lifetime
if she bears children at the current age specific birth
rates. It is calculated from the age-specific fertility rate,
which is the average number of children per year born
to women of a particular age group in a particular
country. Life expectancy rate is another useful
measure to characterize a population. It refers to the
average number of years a person is expected to live.
Life expectancy rates are generally lower in less
developed economies as a result of high infant
mortality rates (IMR). These indicators more or less
reflect the state of the medical facilities in an economy.
Low life expectancies and high IMRs tend to be the
same in economies with low access to medicines,
medical facilities, or assistance.
In Table 9.4, we can see that the total fertility rate in
Africa is a high 5.0, a rate that is about twice that of any
other region in the world. Africa also has the lowest life
expectancy rate at 53, while people tend to live longest
in North America, Europe, and Oceania (mostly
Australia and New Zealand). Furthermore, we see that
the survival rates of new born babies and young
children are very low in the poorer regions of the world-
as can be seen by the very high infant mortality rates.
Table 9.4
Source: United Nations Population Division, World
Population prospects, Highlights (New York: United
Nations 2007)
Life expectancy in developing countries has risen
rapidly as a result of improvements in public health. For
example, 25 percent of the mortality decrease in post
war Sri Lanka was due to the eradication of malaria
(Birdsall, 1988, p. 481). Generally, these advances in
the area of public health have been more important
than rising incomes in increasing life expectancy.
These increases in life expectancy were more rapid
than those achieved by the industrial Countries when
they were at the same level of development in the
nineteenth century. On the other hand, fertility has
declined faster than it did in Europe in the nineteenth
century. This is because of better education, growth in
income, and the rapid movement of the population from
rural to urban areas, as well as the availability of
contraception. Furthermore, fertility declines started at
lower levels of per-capita income although from higher
initial levels.
Fertility and income levels are inversely related,
although the relationship is loose. Figure 9.3 shows the
decline in the fertility rates (if selected Asian countries
from the 1970s onwards as their income per capita
rose.
Figure 9.3
Source: Data From World Bank, World Development
Indicators, 2003
THE THEORY OF DEMOGRAPHIC TRANSITION
Most of the industrialized countries have
passed through three stages of population growth. The
conceptual framework that summarizes this evidence
is called the demographic transition (see Figure 9.4). In
the first stage, when the economy is primarily agrarian,
birth and death rates are both high, with birth rates
slightly higher than death rates to ensure that the
population is growing over time. In the second stage,
which commences when the economy begins to
industrialize, advances in medical technology causes a
dramatic drop in death rates. However, birth rates
continue to be high. In the third stage, when the
economy is fully industrialized, birth rates begin to fall
and catch up with the declining death rate.
Figure 9.4
The experience of the now industrialized economies of
the world suggests that the various phases of
demographic transition took place over a long period,
with noticeable changes occurring over hundreds of
years or so. Stages 1 and 3 imply a very slow growth
of the population, while Stage 2 implies a relatively
rapid rise in population numbers. This creates a bulge
in the age distribution of the population that can
continue for many years. When the population group
within the bulge reaches working age, and until they hit
retirement, the dependency rate-the ratio of those not
working to those working-falls to a lower level. Before
and after the bulge, the dependency ratio is much
higher.
This depiction of demographic transition is supported
by evidence from a wide variety of economies.
However, the relationship is more dramatic when time
series for individual countries is analyzed compared to
a simple evaluation of cross-section data for a panel of
countries. This is because demographic transition
takes place at different times for different countries and
the slope of the curves may be slightly different.
Nevertheless, both time-series and cross-section
studies generally support the demographic transition
paradigm.
DETERMINANTS OF FERTILITY AND BIRTH
RATES
There are two approaches to the discussion of
fertility and birth rates. The first is an economic
approach that analyses these issues within a demand-
and-supply framework. The second approach is more
eclectic and brings other factors into the fertility
equation.
The Economics of Fertility
The economic approach attempts to explain
determinants of childbearing using what is called the
microeconomic theory of fertility. In this theory, children
are treated just like any other consumer good for which
there are costs and benefits to their “consumption.”
Accordingly, the childbearing decision of a household
can be represented within a traditional demand-and-
supply framework (see Figure 9.6). The demand curve
for children is assumed to be downward sloping,
implying that the more expensive children are, the less
of them will be demanded. This is captured by the line
D1. For simplicity, we assume a uniform marginal cost
curve MC though there is no reason why this curve
cannot be downward sloping as well because of the
economies of scale associated with increasing
numbers. Given the D1 and MC1 lines, the desired
number of children is determined by the point where D1
= MC which corresponds to the point q]. In this
framework, the desired number of children can be
reduced by an inward shift in the DI line and/or an
upward shift of the MC curve. The new equilibrium
points associated with the new demand and marginal
cost curves result in having either q2, q3, or q4
children, all of which are less than the originally desired
number of q1. This cost-benefit approach to fertility
choices is associated with Gary Becker ( 1981).
Figure 9.6
We can extend the analysis a little further to
understand the effect of changing family situations on
fertility choices. In Figure 9.7, the number of children is
represented on the horizontal axis, and consumption of
commodities is represented on the vertical axis. The
budget line A’ B’ says that with fixed income, parents
Figure 9.7
have to choose between having more children, or
consuming more of other goods. More children imply
having less material goods to enjoy, and having less
children enables one to devote more resources to
material goods. The steeper the budget line, the higher
is the price of children, relative to goods. The slope of
this budget line is therefore a measure of the cost of
having children. An increase in income implies a
parallel outward shift of the budget line AB to the line
A’ B’. Reduced income moves this line below AB and
closer to the origin. There are three indifference curves
in the diagram showing three levels of satisfaction that
may be derived for all the possible combinations of
goods and children that the parents could choose from.
According to the demand-based theory of fertility, the
household chooses the combination of goods and
children which maximizes family satisfaction on the
basis of its subjectively determined preferences. In the
diagram, this is represented by the point e,
corresponding to c1 (children) and g1 (goods).
If family income increases, the household’s budget line
would shift upward to line A’B’. As a result, the family
would adjust its satisfaction levels accordingly and
hence choose c2 (children) and g2 (goods).
An increase in the value or “price” of raising children
can come not just through the increase in the price of
direct “children” expenditures. Sending women to
college and increasing women’s wage incomes
increase the opportunity costs of raising children as
well. Such implied or indirect costs that may be
incurred if good job opportunities or more wage income
has to be given up to have the mother stay home to
care for children instead. An increase in the price of
children relative to other goods can cause households
to substitute commodities for children. In this case, the
budget line will pivot towards the origin around the point
A’, to the line A’B' and cause the household maximizing
utility consumption combination to occur at a lower
indifference curve, at point f.
In summary, Becker’s (1981) model of household
fertility says that the demand for children is positively
related to the household’s income and wealth and
negatively related to the price of children (including the
opportunity costs involved). Furthermore, the demand
for children is also influenced by the price of substitutes
(negatively related), complements (positively related),
and parents’ taste for other goods vis-a-vis children
(negatively related if taste for other goods changes
positively). Evidence suggests that the theory, as far as
it goes, is reasonably accurate.
The Becker model can be modified by introducing the
quality of children as an additional variable and also by
making the quality and quantity of children jointly
determined. If we do this, we find that one of the
interesting results is that since quality and quantity are
substitutes, an increase in the price of one will cause
an increase in the demand for the other. Therefore, if
this kind of substitution takes place, an increase in the
cost of schooling (measure of quality) will lead to an
increase in the number of children demanded.
Conversely, a fall in school tuition fees will lead to a fall
in the number of children demanded. That is, fewer
“quality” children will be substituted for more children of
lower “quality.”
The Demand for Children in Developing Countries
Why is there a high demand for children in the
developing countries? To answer this question, we first
look at the costs and then the benefits associated with
children, as well as the factors that influence the fertility
choices of parents in developing countries. '
THE COSTS There are at least two kinds of
costs associated with children. One is the direct costs
children have to be fed, clothed, kept healthy, and
schooled. Direct expenditures on children vary widely
across the spectrum of economic development. More
importantly, the composition of the expenditure basket
of households with children varies markedly from
country to country. Households in the developing
countries devote almost all costs for child maintenance
on food and other necessities, while those in
developed countries expend a greater proportion of
child expenditures on education, sports, and music
activities, as well as other forms of human capital
investments. In agrarian societies, there is less
emphasis on formal schooling. Therefore, the cost of
raising a child in an agrarian society is lower than in an
industrialized economy where children need to go to
school and parents have to pay for school uniforms,
shoes, bus fares, pocket money, sports and music
tuition fees, as well as child-minding fees. Since the
cost of land and buildings is also lower in the rural
areas, the cost of housing additional children is also
less.
Direct costs are, however, not the main reason that
families in developing countries are much larger in size
than those in developed economies. The more
important element impacting on household fertility
decisions is the indirect or opportunity cost associated
with having children in the family. Indirect or
opportunity cost is measured in terms of the time, effort
and resources foregone in the process of bringing up
children. Most commonly, this includes income given
up by a parent who stays home to look after the child.
In this case, the opportunity cost is roughly equivalent
to the wage rate multiplied by the number of hours
spent in parenting. In rural communities, the
opportunity cost of raising children is low because
women have few opportunities to earn money outside
the home. Once employment opportunities for women
start to open up (with industrialization and more
education perhaps), the opportunity cost of raising
children will rise, thus dampening the demand for
children in these communities.
In this connection, having more children in agrarian
societies is not a hindrance to women’s participation in
the production of services in the rural household. A
common picture that comes to mind is that of women
tending the farm with their babies tied behind their
backs in a cloth bag. Besides, there are grandparents
to help them out in case they choose to leave the
children at home. In contrast, the working environment
for women in industrialized societies is not as
supportive of such arrangements-normally, women
cannot bring their children to work and have to pay for
child-minding services to enable them to work. In
addition, as mentioned above, housing costs may be
higher in an urban setting. Clearly, the opportunity cost
of having children is higher in more advanced societies
simply because of the logistics.
THE BENEFITS Apart from the joys and
pleasures of being a parent, children do bring in a
number of economic benefits to the household, and
these tend to increase demand. In developing
countries children begin to assist in a range of farm and
household production activities at a very early age.
Children in the rural economies are often given such
responsibilities as feeding the pigs, cows, and chicken,
cleaning the animal houses, selling home-grown
vegetables in the nearby market, and looking after their
younger siblings while their parents work in the farm-all
of which add up to the economic production of the
household. Children thus have a very high economic
value to the agrarian household. In an urban setting, in
contrast, such roles for children are limited as they do
not just go to school, but also stay in school for many
more years than children in the rural areas. This raises
the costs of bringing up children in cities and other
urban areas.
Another important reason for the high demand for
children in developing countries is that they are
considered the principal providers of old-age security
for the parents. Why is this so? Unlike the situation in
developed countries where social security institutions
for the elderly are well established, in many developing
countries, retirement funds, pension and such other
systems to support the elderly outside the family are
not well developed, if at all children fill this role. One
result is the common family arrangement of having
parents live with their children in their old age. Contrast
this with the abundance of retirement villages in more
advanced societies. Will this role differ between rural
and urban sectors? Perhaps only when the chance of
getting a government pension is higher in an urban
setting.
Other Factors
In addition to the standard microeconomic
approach of Becker, there are several other factors that
have either direct or indirect effects on the family’s
fertility decision. These effects require a more general
equilibrium approach which provides underlying
reasons why some of the standard variables might
change. In this sense, they are included as second
stage variables that have behavioral ramifications for
fertility.
Better education for women lowers fertility rates and
this important factor works through a number of
different channels. Higher education enhances job
opportunities that raise the opportunity cost of having
children. For educated women, the opportunity to have
higher income, to pursue a career, and/ or enjoy a
certain lifestyle is weighed heavily against having
children. If they have a different preference function for
children than their partners or husbands, educated
women are better able to assert themselves and have
greater input in the decision to have children-when and
how many. More educated women have greater
bargaining power at home. Furthermore, the higher
levels of self-awareness that educated women have
given them greater control over their destiny and their
bodies. Educated women also tend to marry later.
The intergenerational impact of education on fertility
levels needs emphasizing too. Empirical evidence
shows a ripple effect. Better-educated mothers have
better-educated children-particularly better-educated
daughters-and this has important implications for the
fertility decisions of the next generation of mothers. .
The trade-off between the quality and quantity of
children, as noted earlier, is another important
Consideration in having children. In an expanded
version of the Becker model, these two variables are
determined together as the household undertakes its
utility maximization decision. As incomes rise, there is
a substitution effect of quality for quantity that works to
lower fertility. This impact on fertility becomes stronger
when compounded by the effect of having more
educated women in the household, which leads to
having more educated daughters, which in turn can
lead to further substitution of quality for quantity in the
next generation.
Some analysts believe that lower infant mortality rates
serve to lower fertility levels. Olsen (1983) argues this
particularly-for the case of developing economies
where the old-age insurance system is not well
developed. Ray (1998) provides a simple model linking
the demand for children, old-age insurance motive, and
infant mortality rates. His model neatly associates low
infant mortality rates with low fertility rates, though this
is still a strong point of contention in the literature.
Whether this is true or not depends upon the price
elasticity of demand for the surviving children. If the
demand is inelastic, then mortality declines should
reduce fertility. The empirical evidence suggests that
families do not completely replace a lost child. More
than likely, cultural and other factors compound the
true association of infant mortality on fertility level. In
some societies, for example, the status of the father or
mother is associated with the number of children-that
is, the more children (sometimes, the more male
children) one has, the more prestige and respect one
gets from the villagers or community. Such cultural
factors will tend to influence family decisions to
“replace” or not replace an infant who died. The
widespread desire of traditional families to have sons
is continuing to make an impact on fertility levels in
developing countries. In addition, if this preference
remains strong, as it still is in China, India and Korea,
social norms and expectations can raise the probability
of having another child to “replace” a lost son, more
than a lost daughter.
POPULATION GROWTH AND ECONOMIC
DEVELOPMENT
Does population enhance or inhibit economic
development? How? Consider the following definition
of output:
O=LxX
where O is the output level, X is the output per worker,
and L is the number of workers. In per capita terms,
this is equivalent to
O/P = L/P x X
This equation states that output per worker is a
product of two factors: the share of the population that
is in the labor force and the output per worker
(productivity). Each of these factors provides a channel
through which population growth affects economic
growth. In this section, we address one specific
question of this population growth puzzle and then look
at the population growth experience of countries in
Asia. Here, we draw on both economic theory and
empirical evidence to come to a clearer understanding
of this issue.
● Is Rapid Population Growth Undesirable?
If markets work and individuals are making informed
choices in the society, then it could be that rapid
population growth is socially optimal. The right answer,
however, is not so easily obtained, if at all. What do
growth models predict? The growth models studied in
Chapter 3 clearly showed the impact of population
growth on income. In the Solow (1956) model, there
are constant returns to scale and this ensures that a
faster rate of population growth and the labor force will
reduce the capital-to-labor ratio, and therefore, the
productivity of labor. Furthermore, in the Lewis-Fei-
Ranis (1954, 1964) model, labor is absorbed into the
manufacturing sector only insofar as the manufacturing
sector is able to absorb it as a result of technical
progress or capital accumulation. Other things being
equal, population growth will lower the wage rate and
the level of income. Coale and Hoover (1958) also
suggest that a higher population growth rate will reduce
income growth because children consume and do not
produce. Overall, these theories conclude that rapid
population growth is indeed undesirable. On the other
end of the scale IS another group of economic and
political analysts who argue that a rapid rate of
population growth brings many benefits for the
economy and society as a whole. Under this viewpoint,
a rapidly growing population increases consumer
demand, which allows the manufacturing sector and
infrastructure to take advantage of economies of scale
in production, to lower costs, and provide a sufficient
and low-cost labor supply necessary to achieve higher
levels of output. A large growing population also
provides a rich source of labor resources, particularly
for labor-intensive agricultural activities.
There are, therefore, many opposing Views to this
question. In this book, no single answer will exists. If
we take a closer look at the inner workings of
developing and relatively poorer countries, we will
realize that there are external diseconomies that result
from having young, highly dependent populations. The
following sections will discuss each in turn.
POPULATION GROWTH AND NATURAL
RESOURCES Rapid population growth exerts greater
dependence on land, forest, and water resources for
consumption and subsistence. For non-renewable
resources, population growth reduces the time horizon
of usage but not necessarily the per-capita
consumption since the price of the resources will rise
to reflect growing scarcity. For renewable resources,
on the other hand, common property resources may be
overused and could even result in the extinction of
Species. The argument here is that better property
rights are needed to define and circumscribe the use of
these resources rather than to arbitrarily reduce the
rate of population growth. Furthermore, the burden on
the environment must be factored in as one of the costs
of more rapid population growth because the larger the
population, the greater the adverse environmental
impact on the economy as a whole. In other words, the
larger the population; the larger are the negative
externalities.
POPULATION GROWTH AND ADDITIONSTO
HUMAN CAPITAL At the family level, large families
tend to spend less on health and education per family
member than smaller families. However, there are risks
to controlling fertility to address this issue. It could
reduce overall welfare if parents are altruistic and
include children in their utility functions. It is probably
true that elimination of unwanted births would raise
average education levels, and this may be the way to
address this issue (see below). Large family size
reduces the educational opportunities for the children
of such families, and also the rate of saving by raising
the dependency rate.
High fertility harms the health of both mother and
children. While this may be recognized and accounted
for by many families in decision making, it is highly
unlikely in families where women have little or no
bargaining power, as may be the case in rural villages,
or where the literacy rate is low. Family members in
large families are likely to go hungry more than small
families. Again, this may be in the utility function of the
family but there may be a case of moral hazard,
particularly if there are some feeding programs in
place.
POPULATION GROWTH AND INEQUALITY In
developing countries, large families tend to cluster
among the poor. This perpetuates poverty and
exacerbates inequality by lowering the rate of return to
labor and increasing the returns to capital. In addition,
if the poor have more children, they will be worse off
because per-capita income within the family will be
lowered. Large families are also most likely to spend
less on health and education per capita and this will
tend to have a negative impact on income distribution.
If society does not want this to happen for social
reasons, then it is an external diseconomy and justifies
market intervention.
● Policies to Reduce Population Growth in Asia
Apart from rapid economic growth as an
explanation for the demographic transition, it is
possible that the same institutional developments in
health and education that allowed these countries to
reduce mortality rates after World War II were also
brought to bear on fertility and family planning
(Sanderson and Tan, 1995),
FAMILY PLANNING AND CONTRACEPTIVE
USE The relationship between contraceptive use and
fertility rates needs to be negative for any family
planning program to be successful. Various forms of
such programs have been implemented in many
developing countries around the world, but the strength
of that relationship remains unclear in practice. The
wide range of outcomes observed in Southeast Asia
during the 1980s has largely been inconclusive,
particularly when comparing the experiences of
Malaysia, Thailand, and the Philippines. There has
been very little achievement in the Philippines while
significant success has been noted in the use of
contraceptives in Thailand and Malaysia. In the
Philippines, for example, contraceptive use was
reported to be 44 percent; yet total fertility rate was 4.3
births per woman. This compares with 3.5 births per
woman in Malaysia, which reported a similar rate of
contraceptive use. Most likely, there are other factors
besides contraceptive .use to explain these differences
in fertility outcomes.
In India, the network of family planning and
contraceptive facilities, such as buildings and
equipment, is quite extensive, with about 1,100 married
women of reproductive age per fixed facility. This is a
much lower ratio compared with all other countries
except Thailand, where the ratio was 990. However,
progress in fertility reduction does not seem to be
commensurate with the provision of facilities. Perhaps
other supply factors, such as the availability of trained
personnel and birth-control materials, such as
condoms and IUDs (intrauterine devices, are also
important. Furthermore, the demand factors, including
women’s education, may also account for the slow
reduction in fertility in India.
In the Philippines, on the other hand, the important role
of the Catholic Church and the extremely low budget
for resources devoted to population control are
believed to be largely responsible for the lag in
response to fertility rate declines during the past
several decades. Compared with its neighbours at
similar levels of development, fertility rates in the
Philippines are much higher (4.3 versus 2.6 and 3,3
births per woman in Thailand and Indonesia,
respectively, in the late 1980s). Domestic spending
was estimated to be 0.02 percent of GDP in 1988,
much lower than other countries. Furthermore,
programs for fertility control have been primarily the
result of foreign-funded assistance. The government
itself does not have a well-funded comprehensive
program for population control, perhaps because of
pressure from the Catholic Church hierarchy.
In general, the linkage between family planning and the
use of contraceptives is loose since there are
numerous other methods for controlling family size. At
the same time, there have been many studies on the
effect of contraceptives on fertility in developing
countries, yielding a range of conclusions? What can
be safely concluded from all these is that government
initiatives are well in place in many economies, yet their
net effect on family formation continue to be small.
IMPROVEMENT IN WOMEN'S
EDUCATION Experience has shown that in many
developing countries, women’s education has been
instrumental in changing the perception of family size.
This operates through a number of channels, all of
which tend to raise the opportunity cost of having
children, substitute quality of children for quantity, and
provide greater opportunity to women in determining
the 3126 of the family. Improvement in women’s
education has also had a beneficial effect on other
variables, such as overall family health and decline in
infant mortality.
ECONOMIC INCENTIVES AND
DISINCENTIVES In the late 19705, when population
growth was seen as very high in Singapore, the
government imposed tax penalties and social pressure
on those families that had more than two children.
Health and education subsidies for the first two children
“ere generous but the same were severely reduced for
subsequent children. Housing entitlements, in
government housing estates openly favored smaller
families. This two-child policy proved so highly
successful in pushing birth rates down in just a few
years that the problem has now been reversed. More
recently, the Singapore government resorted to the
same economic incentive and disincentive schemes,
but this time to encourage couples to have more
children; Tax benefits increased with larger family size.
In addition, health, education, and housing benefits to
families increased with more children in the family.
Similarly, in an effort to increase the natural growth rate
of its population, the Australian government provides a
one-off payment of A$5,000 to families with the birth of
every child. This was started in 2005 solely for the
purpose of increasing fertility rates and works
alongside other cash allowances and family benefits
already in place for many years. Generally, a
progressive tax system and reorientation of the subsidy
system could be introduced if a strong population policy
is deemed desirable. Surprisingly, very few countries in
Asia have used this approach.
COERCION AND QUOTAS In India, there was
a time under Indira Gandhi when sterilization for men
was encouraged. Sometimes coercion was even used.
In China, the government instituted a one-child policy
in 1982 to curb the growth of its already large
population (see Box 9.1 for greater details of
population policies in China since the 1950s). This
approach put a clear break on the nation’s accelerating
fertility rates, but it also brought with it a number of
unintended consequences. The policy appears to have
resulted in more rampant corruption in certain
localities, as well as a significant increase in infanticide,
particularly of baby girls, since many families preferred
having sons to daughters. The one-child policy in
China has thus had its share of harsh critics from
around the world. More generally, such coercive
policies do not leave the fertility decision to the
individuals themselves. They effectively impose a
relatively more severe welfare burden on poorer and
rural-based households, as they would be the ones
who would prefer and benefit from having more
children in the family.
BOX 9.1
China’s Population Policy Experiment
China's population was recorded at 1,271 million in
2001 (ADS, 2002), making up one-fifth of the world's
population. Being the most populous country in the
world, it is not surprising that its demographic
makeup would eventually be of political interest.
Throughout history, various population control
campaigns have taken place. These policies have
ranged from being suggestive to radical, with varying
degrees of effectiveness.
Prior to the 1950s, population growth was not of
much concern. The government of the day believed
that’…..even if China’s population multiplied many
times, it [China] would find a solution." This opinion
rapidly changed in the early 19505 when China's
population ballooned to more than half-a-billion! This
provided the impetus for a comprehensive
population control program to be put in place.
Contraceptive manufacturing thus began in the mid-
1950s and the first family-planning program was
thus implemented. Although the campaign was
stopped because efforts were directed to the Great
Leap Forward and communization movements, it did
pave the way for future birth-control programs.
The second birth-control campaign began in 1962
and provided a guide to the ideal number of children,
with slogans such as “Two children is just right, three
is too many, and four is a mistake”. The campaign
was complemented by an incentive program that
rewarded families with a small number of children
(through income, grain and housing subsidies, and
even free land). These benefits were withdrawn
once a family exceeded a threshold number of
children. The Cultural Revolution also assisted the
campaign.
Family planning was promoted in earnest from 1971.
Adjusting childbearing norms was the focus of this
pot icy which was reasonably effective: ”Wan, Xi,
and Shao.’ which meant later marriages, longer birth
intervals (4 years), and fewer children (2) were the
encouraged norms. By the end of 1978, the birth rate
had been halved to 12 per thousand in just a matter
of eight years. Despite such reductions in population
growth, political leaders were concerned about the
cohorts born in the 1950s and 1960s reaching child
bearing age in the 1980s. It was inevitable that
population growth would soar. In response to their
concerns, a policy far more ambitious than any other
before, was put in place. The 'one child per family"
policy was announced by the government at the end
of 1978. By September 1980, the campaign was
carried out vigorously.
The policy provided financial and housing incentives
to families who held one-child certificates. Families
who had more than one child faced penalties,
including, deduction of a fixed percentage of salary
and loss of preferences for government subsidies.
Some special considerations were given to minority
Chinese under exceptional circumstances. Despite
being so ambitious, the policy did not halt population
growth as effectively as the ”Wan, Xi, and Shao
campaign.
The radical policy also raised a number of ethical
questions. Firstly, policy ineffectiveness arose
because policy can influence demographic changes
only to a certain extent. The previously suggested
policies had already adjusted the norms and in the
rural areas, legislation had been met with resistance.
The ethical concern was the family’s preference for
boys. This culturally instilled preference has led to
reports of infanticide, selective abortion of female
babies, and higher rate of girls being put up for
adoption. The male to female ratio by 2000 is 117
boys to 100 girls. Ethics aside, it is predicted that in
the future many eligible bachelors will find it difficult
to find a wife, due to the scarcity of women.
Thus, since the late 1990s, China has started
reconsidering its one-child family-planning program,
in view of external pressure exerted by human rights
groups and the United States. By early 2000, the
government had further relaxed its policy and
permitted two "only child"couple5 who marry to have
two children. In the meantime, there have been
changes in the desirable number of children in
Chinese households arising from economic
progress and rising costs of living. The desired
number of children in the rural areas has shrunk to
two and the figure is even lower in urban
households. The New Population Law passed in
2002 takes a far gentler approach than that of the
19805. The government emphasizes the importance
of informed choices, preferring to influence the
masses through family education, reproductive care,
and proper contraception methods, leaving them to
voluntarily decide upon family size but with due
adherence paid to the relevant policies and
regulations. Furthermore, in order to protect the
rights of civilians, government officials who use
coercion to implement the family planning program
will now be subjected to criminal laws.
The Empirical Argument: Seven Negative
Consequences of Population Growth
According to the latest empirical research, the
potential negative consequences of population growth
for economic development can be divided into seven
categories: its impact on economic growth, poverty and
inequality, education, health, food, the environment,
and international migration.
Economic Growth Evidence shows that rapid
population growth lowers pet capita income growth in
most LDCs, especially those that are already poor,
dependent on agriculture, and experiencing pressures
on land and natural resources.
Poverty and Inequality Even though aggregate
statistical correlations between measures of poverty
and population growth at the national level are often
inconclusive, at the household level the evidence is
strong and compelling 11m negative consequences of
rapid population growth fall most heavily on the poor
because they are the ones who are made landless,
suffer first from cuts in government health and
education programs, bear the brunt of environmental
damage, and are the main victims of job cuts due to the
slower growth of the economy. Poor women once
again bear the greatest burden of government austerity
programs, and another vicious cycle is set in motion.
To the extent that large families perpetuate poverty,
they also exacerbate inequality.

Education Although the data are sometimes

ambiguous on this point. it is generally agreed that
large family size and low incomes restrict the
opportunities of parents to educate all their children. At
the national level, rapid population growth muses given
educational expenditures to be spread more thinly,
lowering quality for the sake of quantity. This in turn
feeds back on economic growth because the stock of
human capital is reduced by rapid population growth.

Health High fertility herms the health of mothers and

children. It increases the health risks of pregnancy and
closely spaced births have been shown to reduce A
birth weight and increase child mortality rates.

Food Feeding the world's population is made more

difficult by rapid population growth-over 90% of
additional LDC food requirements are caused by
population increases New technologies of production
must be introduced more rapidly, as the best lands
have already been cultivated International food relief
programs become more widespread.

Environment Rapid population growth contributes to

environmental degradation in the form of forest
encroachment, deforestation, fuel-wood depletion, soil
erosion, declining fish and animal stocks, inadequate
and unsafe water, air pollution, and urban congestion.

International Migration Many observers consider the

rapid increase in international migration, both legal and
illegal, to be one of the major consequences of
developing countries’ population growth. Though many
factors cause migration, an excess of job seekers
(caused by rapid population growth) over job
opportunities in the LDC economy is surely one of
them. However, unlike the first six consequences listed
here, some of the economic and social costs of
international migration falls on recipient countries-
increasingly in the developed world. It is not surprising,
therefore, that this issue has recently taken on political
importance in North America and Europe.

*** END of LESSON 14 ***

LEARNING CONTENT
Introduction:
Despite sustained economic growth in many
developing countries, poverty remains widespread. In
2005, 25 percent, or about 1.4 billion people around the
world lived in poverty. Asia is host to a vast majority of
the world’s poor-there are 207 million in China and 455
million in India. Overall, Asia is home to more than 911
million people who struggle to meet basic food,
clothing, and housing needs that is, 66 percent of the
world’s poor are found in Asia (World Bank, 2008).
Equally disturbing is the fact that the gap between the
rich and the poor has grown, rather than diminished,
with the sustained growth in income. In 1960, the
richest twenty economies in the world had per- capita
incomes that were about eighteen times greater than
the poorest twenty economies. After thirty-five years of
record growth in total world income, this income
differential has more than doubled (World Bank, 2001).
Within countries, similar trends can also be observed,
that is, that the fruits of economic gains over the years
have accrued only to a select few.
Lesson Proper:
The Vicious Circle of Poverty and Inequality
The alleviation of poverty and minimization of
economic inequality is at the core of all development
policies. This is rightfully so because children who are
born into poor households will have lesser
opportunities than those in richer ones. The impact of
such differences is more marked in developing
Countries where the government faces greater
constraints in its ability to provide much needed
assistance to improve the lot of their poor citizens.
It is not hard to imagine how life evolves for children
living in an urban slum area of Mumbai. Manila, or
Beijing. Very young children are sent out to earn money
by doing menial jobs such as peddling Cigarettes on
the streets. The children earn (little) money at the
expense of attending school. Parents who are
uneducated tend not to value education highly, and
even if there were some incentives to educate their
children, the opportunities to send their children to a
good school are limited.
Furthermore, the sacrifice required to send a child to
school is substantial, even if tuition charges are low.
The cost of clothing/uniforms, transportation, and
books are quite high relative to the income levels of the
poor.
Children raised in poverty have no peer groups or role
models to instill in them the virtues of education and
human capital acquisition. Since everyone around
them is poor, there are no opportunities for building up
either human or physical capital. In many cases, drugs
and crime (and perhaps Sport) are the only ways out of
this low-level trap. When they are old enough, they
begin to have children and the cycle of poverty is
repeated.
Unless this cycle is broken for many families, the result
is the perpetuation of poverty to successive
generations. In addition, the gap between the rich and
poor in the society will be perpetuated and perhaps get
worse.
Is climate a factor?
In the past, some economists have talked
about a climate theory of development. Specifically, it
was propositioned that a temperate climate provides a
more conducive environment for economic growth.
Statistics show that this theory is not without basis.
Almost all successful and modern industrial economies
are situated in the temperate zone, or the colder places
of the world. In contrast, almost all developing
economies are situated in tropical or subtropical
climatic zones. Extreme heat and humidity does affect
conditions of production-as heat causes a more rapid
rate of soil deterioration-as well as causes the rapid
deterioration of other natural resources. The health of
the workforce in warmer countries is also more
adversely affected as there is greater frequency of air
and water-borne infections, and diseases spread more
rapidly. In addition, working in a warmer climate is more
taxing on the physical body, and hence, labor
productivity tends to be lower.
While the climate theory of development has long been
debunked in favor of other theories, a recent study by
Gallup, Sachs, and Mellinger (1999) provides fresh
evidence for this theory. Mapping out the latest data on
gross domestic product (GDP) per capita, they observe
that countries in the geographical tropics are nearly all
poor and that almost all high income countries are in
the mid and higher latitudes. Their comprehensive
analysis of the complex relationship between
geography and growth reveals that tropical regions are
indeed hindered in development relative to the
temperate regions, and attribute this to the higher
disease burden and limitations on agricultural
productivity in the tropics. Their study demonstrates
that climate, and geography in general, continues to
matter greatly for economic development, alongside
the importance of economic and political institutions.
From an analytical point of view, they strongly
recommend the reintroduction of geographical
considerations into the econometric and theoretical
studies of cross-country economic growth.
MEASURING POVERTY AND INEQUALITY
Poverty, in its broadest sense, means the
inability to access for a minimal or acceptable standard
of living. This loose definition, however, contains
subjective notions, reflecting the fact that what one
needs or finds “acceptable” or “minimal” is a very
relative matter. Poverty standards and definitions thus
vary’ across different countries.
The concept of inequality can be more easily defined
but is no less contentious. Economic inequality refers
to the uneven distribution of income or expenditures
across population groups. According to some, these
income gaps are inevitable consequences of growth
and development and will correct itself in due course.
Others, however, believe that observed gaps can be
avoided or at least minimized through government
intervention. This implies policy interventions aimed at
assisting disadvantaged groups to improve their
situation. Clearly, these two concepts of poverty and
inequality are complex and very much interrelated. In
this section, we define some objective measures first
and then return to these and other related issues.
Measurement of Poverty
In development economics, poverty is
generally defined as the inability to access resources
to enjoy a minimal or acceptable standard of living. This
definition is simple, intuitive, and easy to understand.
However, minimum needs or acceptable standards of
living vary from country to country, from individual to
individual, in accordance with one’s cultural, economic,
and social norms and expectations. Hence, this broad
definition is not very useful when measuring poverty,
and even less so when making cross-country
comparisons.
At the subsistence level, poverty can be defined in
more absolute terms, and this means identifying the
poor based mainly on a universally accepted
benchmark of physiological, economic and social
requirements for survival. This is a standard approach
in development economics which works well to
operationalize the concept of poverty. In this section,
we will use this “absolute poverty" approach to facilitate
the discussion on measurement, but this does not
imply that we are any less concerned about the relative
aspects of the poverty issue.
Most measures of poverty require that a poverty line be
specified. The poverty line is a chosen level of income
or consumption below which one is considered poor.
This critical threshold point usually represents the
minimum “acceptable” income or consumption with
which individuals are able to achieve a minimal
standard of living to maintain health and well-being.
This definition will vary. Sometimes it is based on the
purchasing power equivalent to buy a minimum caloric
intake and no more. In very poor countries, such as
India for example, poverty lines are calculated by using
estimates of expenditures required to guarantee a
minimum consumption of calories. This caloric
estimate would be the intake required to maintain
health and ability to work. In wealthier countries, a
clothing and shelter component is often added. Since
there is no uniform standard for determining poverty
lines, it is difficult to make accurate comparisons of
poverty across countries or even within the same
country.
Measurement of Inequality
When an economy achieves economic growth
and development, the benefits are ideally filtered down
to each one (individual or household) in the society.
Unfortunately, this does not necessarily happen. It is
more common for the so-called “fruits of development”
to accrue to some members of the society more than
others. In other words, the rich gets richer and the poor
gets poorer. If this is indeed true, then it is certainly a
matter of ethical concern: is this right? If not, what is
the ideal distribution? What is fair? But does it really
matter? After all, “a rising tide lifts all boats” is often the
counter argument used by people who say that we
should not worry about it. Some also say that a small
amount of inequality in the distribution of income is
necessary so that the economy will continue to grow
and develop.
This is clearly a complex issue. Before we delve into it,
let us first get acquainted with a number of basic tools
and measures that should be useful along the way. In
the following sections, we look at common measures
of inequality and a framework for analyzing inequality
and economic growth/development. We also look at
trends of income distribution across selected countries.
Basic properties of inequality measures
Conflicting results displayed by conventional inequality
measures have been a major source of dissatisfaction
among practitioners in the field of income distribution
analysis. The overwhelming conclusion, after several
years of debate and discussion, is that there is no
single best measure of economic inequality mainly
because the concept is essentially a normative one.
Researchers today are more confident in using
different measures. The choice of a measure is highly
dependent on the particular aspect of inequality in
question. There are, however, three basic properties
that inequality measures must satisfy, and they are as
follows:
1. Mean or scale independence. This property holds if,
when all income levels are increased (or decreased)
by the same proportion, the inequality measure
remains unchanged. In other words, the measure
must be independent of the scale of which income is
measured.
2. Population-size independence. This property holds if
an equal increase or decrease in population across
all income levels does not result in a change in the
inequality measure. Inequality should remain
unaffected if a proportionate number of persons are
added at all income levels. We should then be able
to compare the inequality level in the small state of
Singapore and the large country of India or China.
3. Pigou-Dalton transfer sensitivity. This property holds
if an income transfer from a wealthier person to a
poorer person that does not make the latter wealthier
than the former brings about a, decrease in the
inequality measure. This property requires that the
inequality measure be sensitive to transfers at all
income levels.
In many studies analyzing income distribution, a fourth
property called decomposability is added inequality
measure has this property if it can be broken into
several components-either factor for by income source
or by population. This is a useful property for identifying
sources of inequality in populations.
Is Inequality a Necessary factor for Growth?
The validity of the Kuznets inequality curve
hypothesis remains unresolved. The conflicting results
from empirical studies have fuelled debates about the
effect of growth on inequality levels (and vice versa)
and what this implies for national development. On the
one hand, many economists say that inequality is
unavoidable in the process of growth and that, in fact,
it is necessary so that growth can be sustained. The
main argument of this group is based on the belief that
high personal and corporate incomes generate savings
and investments, which is an important element of
growth. In this sense, some people need to be rich to
be able to perform this role in the economy.
Accordingly, higher inequality is equated with higher
growth and any attempts at redistribution (of income or
assets) will only lead to lower growth. Such
redistribution attempts are thus seen as defeating the
purpose of development as it can only lead to longer
periods of inequality.
There are many counter arguments to this line of
thinking. While many development economists agree
that savings and investments are important ingredients
for growth, the rich in developing countries are not
known to have frugal lifestyles, focusing mainly on
saving and investing. In fact, many rich families in
developing countries are known to splurge on luxuries.
In particular, their excessive expenditures on
international travel and overseas shopping sprees,
jewelry, and acquiring properties in other countries do
not really help domestic demand!

It was also been pointed out that low incomes and low
living standards can only lead to lower growth because
it limits the ability of individuals to reach their full
potential. We know that people with higher educational
levels work better, more efficiently and thus have
higher productivity. It is the same with healthier
individuals.
Figure 10.7 Inequality and trade
Another important argument why inequality should be
addressed via higher incomes is that an economy An important point to note here is that East Asia has
made up of households and individuals with higher been able to minimize significant increases in
incomes and living standards demand more consumer inequality as it promoted a trade based growth
goods. Attempts to equalize incomes in such an strategy. This has been made possible by an emphasis
economy are thus helpful in stimulating domestic, on trade, without a natural resource base (see Figure
demand-and therefore assist economic growth in this 10.8 comparing human capital and natural resources
way. for 1995). Latin America and Africa; on the other hand,
have substantial natural resources but have not been
It has also been pointed out in the literature that when able to convert these assets into rapid growth or trade.
people are able to share in the so called fruits of Educational levels have not been an obvious
development-by experiencing higher standards of advantage or disadvantage in this regard. The average
living as the economy progresses-they are more level of schooling in Latin America and East Asia is
encouraged to actively participate in the development about the same.
process. This has an important psychological effect
that is greatly beneficial to national development goals. Figure 10.8 Human Capital and Natural Resources,
1995
Finally, it is important to recognize that of the two ways
of raising incomes, by reducing inequality or by raising
the growth rate in per-capita living standards, the latter
is by far the more important approach. It would require
an enormous adjustment in the distribution of income
to achieve the same addition to living standards for the
poor as an additional percentage point of sustained
growth. Furthermore, as we have seen by looking at
the data for Asia, this kind of remarkable shift in income
distribution has not occurred and is not likely to happen
in the future.

How does inequality relate to openness?

Is there a relationship between openness and

income inequality in a country? This question is
relevant if we want to evaluate the trend in
globalization, which will be mentioned again in the last
module to be given. We discuss it here because it is an
important and interesting relationship that bears on our
study of poverty and income distribution. Juan-Luis
Londono (2002) presents a fascinating figure that
shows the relationship between the Gini coefficient and Who are the poor?
the intensity of trade (exports plus imports divided by
GNP) for the various regions of the world in the mid The following groups of people have been repeatedly
1990s. Figure 10.7 shows that East Asia has a much identified and proven to be the most vulnerable
higher rate of openness and a low Gini coefficient, as members of the national community because of their
low as any other region besides Europe and almost as poverty.
low as the United States, Australia, Canada, and South
Asia. Africa and Latin America have much higher levels RURAL DWELLERS People who live and work in the
of income inequality, while their exposure to trade 1s rural areas of the world are more likely to be poor. In
also smaller. Asia and Africa, rural poverty accounts for over 60
percent of the total population and often over 80
percent of total poverty. In Latin America, it is less than
50 percent because of higher urbanization levels.
WOMEN Women constitute over 70 percent of the
world’s poor-particularly households headed by
women. A combination of current and past
discrimination is responsible-low education and health
indicators are the primary reasons for women’s
poverty. Recent studies indicate a greater likelihood for
households headed by women to be poor compared
with those headed by men.
CHILDREN On average, children are poorer because
the poorer households tend to be the bigger families.
Children born into poor families will have lesser
opportunities compared with those born in richer
households. For a start, they will have a lower survival
rate during infancy. As they grow older, it is also more
likely that crucial opportunities in health care and
education will be denied to them by default. Such
children will have to share limited family resources
(e.g., food, clothes) with more siblings and they will be
asked to work and contribute to the family coffers at a
very early age. In societies where there tradition values
males above female children, girls are even more
disadvantaged in the poorer households.
ELDERLY The elderly in developing countries tend to
depend solely on their families to look after them in
their twilight years. While this is traditional and most
children would not turn away from such responsibility,
the burden of looking after aging parents in households
with very limited resources is not an easy one because
poorer households tend to have larger numbers of
children. On the one hand, elderly parents can look
after the children while parents go to work, but the
health and welfare of the elders tend to suffer. Where
governments provide little, if no support for the medical
needs of their elderly population, medicines, health
checkups and trips to the doctor can be a burden to the
poor.
ETHNIC MINORITIES Ethnic minorities and
indigenous populations are generally poor for similar
reasons such as discrimination and because they are
rural-based-American Indians, Indians in South
America, aboriginal people in Australia, Kurds in Iraq
and Turkey, Tamils in Sri Lanka, Tibetans in China, hill
tribes in Thailand, and the Philippines. In the United
States and Australia, the human welfare indicators-life
expectancy, infant mortality, nutrition and education-for
indigenous populations are much lower than for the
rest of the population.
Why are some people poor?
There are three fundamental reasons why people are
poor. These are as follows:
1. They have a very low stock of human capital, such
as education, training, or skill development. In India,
over 70 percent of heads of poor households are
illiterate compared with about 30 percent in the
general population and much less for those above
the poverty line.
2. They have a very small amount of physical capital,
such as land or machinery. Those lacking education,
minority groups, children, and the elderly are
generally poorer. This is because there is limited
access to land and irrigation facilities. Those without
access to land have a much higher incidence of
poverty. Much of the evidence shows that tenants do
as well as owners, other things equal, and contrary
to some popular beliefs, are also no slower than
owner-operators in implementing new technology.
3. Even if they have physical and some human capital,
their employment opportunities may be blocked
because of discrimination-for example those living in
backward or bypassed areas such as the northeast
of Thailand which gets little water, the dry areas of
Baluchistan in Pakistan, and the outer islands of
Indonesia.
Within the household, the burden of being poor rests
unequally among the members. Inequalities among
household members-that is, who gets the more
favorable treatment for resources such as education
and health, etc.-tend to be highly correlated to the
member’s (potential) capacity to earn income. Those
who are denied opportunities tend to be females, both
adult and children, and the elderly. This happens as a
decision not of individuals but as a family or a
household-a decision that is manifested in the actions
of each family member-including those who are denied
the opportunities themselves. How this decision is
reached is beyond the scope of this chapter. However,
it is worthwhile to note that an increase in the level of
women’s education has been shown to bring with it
greater bargaining power in the household, and more
resources to the children (especially female children)
and better care for the elderly.
Rural Versus Urban Poverty
Within a single country, the poor exists in both rural and
urban areas (see Table 10.6). Particular aspects of
poverty in these two regions can, however, differ
significantly. For example, the incidence of poverty in
the urban areas is commonly known to be lower than
in the rural areas and that the illiterate, women and
children bear the brunt of poverty in urban areas. The
situation is changing rapidly as industrializing cities
attract inward migration from the countryside. That
said, the advent of rural migrants have caused poverty
incidence rates to increase in the urban areas,
particularly in cities where there are no government
assistance programs available to ease the transition
pains for such new city dwellers.
Table 10.6 Urban and Rural Poverty in
Selected Countries
ASPECTS OF RURAL POVERTY Poverty is usually
associated with the lack of ownership of productive
assets. In rural areas, the majority of the poor are found
among the landless tenants or those who own very
small parcels of land. The poor participate in all forms
of rural non-farm employment, largely cottage and
traditional industries, but in general, households with a
significant proportion of income from agricultural labor
tend to be poorer. In Indonesia, this group accounts for
the highest incidence 0f poverty at 38 percent, followed
by self-employed households which have agriculture
as their main source of income. In the Philippines,
roughly two-thirds of the rural poor are engaged in
farming (including fishing). The poor there experience
greater unemployment and inadequate access to
modern agricultural machinery, mainly because they
lack access to credit facilities. As noted above,
education is another productive asset that the poor
generally lack. In Indonesia, Poor households in which
the parents have low education levels have a greater
tendency to keep their children from attending school.
These children are instead asked to help out on the
farm, do housework, or look after their younger
siblings. Hence, net school enrolments are lower
among the rural poor compared with the non-poor in all
age groups, with the difference widening with the
increase in the age of the child. Therefore, there are
high illiteracy rates for poor rural households. For those
who are not illiterate, there is little evidence of
schooling beyond the primary level. Because of their
limited access to productive assets, the rural poor have
limited capacity to improve their productivity. If some
own a small parcel of land, there are limited economies
of scale to be gained from improving land productivity.
Additionally, because they generally have only a few
years of education, poor farmers also tend to be ill-
equipped to absorb new knowledge on how to increase
farm yield through new technology. The spillover
effects of technology transfer will also be limited. The
poor generally have a very short planning horizon.
They tend to favor solutions to problems that take effect
immediately rather than concern themselves with long-
term strategies. Physically, the incidence of sickness
may be higher and illnesses may last longer and be
more debilitating since the poor have limited access to
medicines and medical facilities, and are more likely to
be exposed to unclean water and poor sanitation.
ASPECTS OF URBAN POVERTY Unemployment in
rural areas drives people to migrate to urban areas-and
migrants form the majority of the urban poor. Since
most new migrants will not have much financial and
physical capital to begin with, they will have to rely on
the educational or vocational training they have had
prior to the migration. Lack of such training and/or skills
reduces their chances for employment and this has
been identified as a major factor for poverty in urban
areas. A vicious cycle of poverty perpetuates. Poverty
results in high dependency rates, low education of
children, and low wages, as well as significant periods
of underemployment.
Unemployment rates are not a good index of
employment for urban areas. These measured rates
are low, but underemployment is very high in many
cities. Unemployment is low simply because someone
in the family must earn money or the family will starve-
there is no social security system in these countries.
Where do the urban boar work? The urban poor are
predominantly self-employed or engaged in small-
scale enterprises. They rely heavily on work in small-
scale enterprises. In Asia, they operate small shops
and service establishments, sell food and cigarettes,
hawk lottery tickets and newspapers, repair cars and
bicycles, transport passengers in pedicabs and
motorized tricycles, collect and reprocess trash and
scavenge in garbage dumps. In all the major Asian
cities, there are many families who eke out a living by
gathering and selling items collected from huge
garbage dumps.
Poverty affects all markets
CREDIT MARKETS The poor cannot borrow from
formal credit markets because of the lack of collateral.
Therefore, in case of an emergency or to smooth
incomes, they have to go to informal markets which
charge higher rates of interest.
GOODS MARKETS Since the poor have very low
incomes and cannot afford the cost of storage, they
cannot buy in bulk. Thus, the cost of goods per unit is
higher, often much higher than when purchased in bulk
and stored.
LABOR MARKETS In urban areas, the poor tend to
find themselves living in poor communities Called
ghettos, in the fringe of cities. Employment
opportunities in ghettos are limited and it is necessary
for them to find employment far from their place of
residence. Therefore, transportation expenses as a
proportion of income incurred by the poor may be much
higher than for other income groups. Poor nutrition
contributes to low income by reducing energy levels
increasing the incidence of sickness and disease, and
making the poor a bad employment risk.
Policy: What can be done?
Rapid economic growth, more than any other
factor, reduces poverty even if income distribution
worsens. Unless there is rapid growth, strategies that
stress social spending on the poor may work for a time
but will eventually collapse under the burden of high
spending. The experience of Sri Lanka is a case in
point. In the mid-1980s, the Sri Lankan government
embarked on an ambitious social assistance program
which was helpful in alleviating the plight of many poor
people in the economy. The program, however, did not
coincide with a significant growth of the economy and
could only be financed by larger and larger budget
deficits. In the end, these programs had to be cut back.
They were not sustainable because economic growth
was too slow to sustain them.
There are other factors that complement growth
strategies to address poverty concerns. Agricultural
extension to small farmers can be very helpful when
properly packaged with local support and input.
Spending on rural infrastructure, particularly roads and
sewage, can raise the standards of living in bypassed
areas by opening up markets for agricultural products
and permitting capital to flow into the region more
freely. This spending is more effective when channeled
to local authorities rather than undertaken by the
federal government. Subsidized credit is usually
ineffective in helping the poor since it is co-opted by
other groups. Group lending, cooperatives, and rural
development banks following the Grameen Bank
(Bangladesh) model have been moderately successful.
Experience has also shown that appropriate currency
exchange rates and open trade regimes can help to
absorb labor and reduce poverty. Schemes to
redistribute physical assets and land generally do not
work in alleviating poverty. Land reform has been
successful in a few cases but it is generally a failure.
Establishing secure tenancy rights, with inheritance,
have been more successful.
Longer-term strategies must always include the
provision of education and health programs to all
citizens. Experience has shown that the rates of return
to education are very high. Health programs have also
proven to be very helpful in the long term.
Some general policy prescriptions
Many policy options have been suggested for
poverty reduction. Some of these policies have been
successfully implemented in a number of countries but
that does not guarantee that a particular measure will
work in all countries. This is because many of these
measures are difficult to implement. There is also
usually some pervasive discrimination against the poor
throughout the entire economic system. Some
measures that have been effective include:
1. Removal of distortions that stimulate capital-
intensive production technologies-such as exchange
rates, subsidies and tax breaks, and preferential
tariffs.
2. Redistribution of assets in the form of land and
physical capital.
3 Development of a human capital base for those who
are poor in terms of better access to education, on
the job training, and other programs to develop skills.
4. Implementation of a progressive tax system and
imposition of high taxes on transfers of wealth within
a family. Such a policy will help the government to
implement its social objectives and prevent families
from developing wealth dynasties.
5. A program to increase subsidies and direct transfers
to the poor. Case studies of Sri Lanka and Tanzania
are instructive. These two countries managed to
raise life expectancy, lower infant mortality rates and
improve educational levels through programs
targeted at the poor. As a result,
social indicators such as life expectancy,
literacy, and infant mortality have improved greatly
compared with other countries with similar levels of
per-capita income. They succeeded very well for a
time but the program became difficult to sustain when
economic growth faltered.
Some policies for addressing Rural Proverty
UPLIFT THE STATUS OF WOMEN In landless
households, women experience a number of problems
and challenges, particularly in South Asia, during the
slack period in the agricultural season. Because of high
infant mortality rates and poverty, landless families
generally have relatively small families. Where some
land is available, family sizes tend to be larger as
children can do some chores. They can also diversify
into truck gardens, raising livestock, and so forth. Thus,
there is a need to provide more land, or some land, to
landless women and also some employment during the
slack season. For these families and the women in
particular, work opportunities should form the most
important thrust of public policy. For families with some
land, improving agricultural efficiency can increase
household incomes. Greater emphasis on truck
gardening and improvement on animal husbandry
would help. Greater emphasis could also be given to
health and sanitation which would help women to save
time and energy in doing their household chores.
RELAX TENANCY REGULATIONS With respect to
land reform, governments should relax tenancy
regulations rather than try to undertake further land
reforms. Furthermore, the evidence is not strong that
land reform has served the purpose of reducing
poverty. It is also very difficult to enact, particularly in
countries where the entrenched interests are strong.
Land reform in Latin America is a good example.
CHECK RURAL CREDIT SCHEMES In the field of
rural credit, there are stereotypes of the unscrupulous,
gouging penny-pinching money lender who charges
high interest rates to the unsuspecting poor. A
benevolent government, by providing agricultural credit
can do much to lift the poor onto a higher income
plateau. Evidence suggests that the benefits from rural
credit are minimal in most situations and informal credit
markets are often competitive and charge high rates to
compensate for the high risks of lending to poor
marginal farmers. Therefore, it is important to carefully
evaluate government programs to assess whether they
actually improve economic efficiency in a situation
where the availability of financial resources to rural
households is constrained.
ENCOURAGE LABOR MIGRATION Seasonal and
long-run labor migration will help to reduce poverty in
the rural areas, which is usually much higher than in
the urban areas. This would be of particular benefit to
landless peasants. Since urban areas are also growing
relatively faster than rural areas, particularly where
openness and industrialization have promoted rapid
growth, policies to facilitate such movements would
yield high returns. Information networks subsidized by
the government could also help to facilitate rural to
urban migration. The elimination of bureaucratic
restrictions on migration would also help. The case of
China is a good example. There has been a massive
internal migration from the central and western
provinces to the eastern and coastal provinces,
particularly to the Pearl River delta area and to the
export processing zones, as well as Shanghai and
the Pudong area. Initially, the government discouraged
such migration and refused to provide any support to
the migrants. Now migrants can avail themselves of
some subsidized food although they are still illegal in
the sense that they do not have residence permits.
PROVIDE RURAL INFRASTRUCTURE Provision of
rural infrastructure, particularly in the poorer areas, can
improve the integration of bypassed and backward
regions into the mainstream of economic activity and
increase the poor’s access to markets. This is
particularly true of roads and access to electricity.
Studies of rural road networks show high returns to
secondary roads, particularly where they are linked to
growing urban markets for rural produce. These road
networks also permit easier access of migrant labor to
the cities. Generally, greater integration of the rural
areas with the rest of the economy is desirable,
although there are some risks, since there will be a
reduction in self-sufficiency. Many studies on the rates
of return to various rural projects show that road
construction and improvement is one of the most
effective ways to increase incomes in rural areas.
APPROPRIATE CURRENCY EXCHANGE
RATES When exchange rates are overvalued, it taxes
exports and subsidizes imports. Both of these actions
hurt the farmers. By modifying the currency exchange
rate regime, the terms of trade for the agricultural
sector are improved and rural incomes will rise. Other
policies that promote rapid growth are also useful since
they create employment opportunities and induce the
marginal farmers and the landless to move into
industrial sector employment. This process has
resulted in virtually full employment in Korea, Taiwan,
and Malaysia, and to a lesser extent. Thailand.
ESTABLISH PROPERTY RIGHTS It is important to
establish property rights. If this is not workable then
security of tenure and the ability to sell the ownership
rights should be established. In Thailand, for example,
forests have been converted (illegally) to farming. Yet,
even though the land has been farmed for many years,
the tenants have little incentive to undertake
improvements that would raise productivity because
without the proper ownership documents, there will
always be the possibility of poaching or that the
government will confiscate their land. There are also
adverse environmental effects to these policies.
Secure tenancy brings with it the possibility of using the
land as security to borrow funds, to undertake
improvements, and to adopt better and more efficient
technology. In Thailand for example, more secure
tenure would allow farmers to take up part-time
employment in the urban areas during slack seasons
without the risk of losing their land to other poachers
because they have security of tenure.
Some policies for addressing Urban Proverty
ACCELERATE ECONOMIC GROWTH Since there is
no land to redistribute and the provision of
infrastructure is not so much of an issue, the major
“poverty alleviation” policies required in urban areas
have to be geared toward increasing the rate of income
growth. Local business and domestic production need
to be encouraged and promoted. An appropriate
currency exchange rate is important in urban areas
because an overvalued exchange rate makes capital-
intensive imports cheaper and impedes the
development of labor-intensive manufacturing
activities. In other words, an overvalued exchange rate
would stifle the economy's ability to support small local
businesses and also penalize those which
manufacture for export. On the other hand, a market-
determined exchange rate would be more stimulating
to the local economy. The increased production
activities will generate more employment and be much
more effective in raising the living standards of the
poor.
PROVISION OF SOCIAL SERVICES Provision of
social services such as education and health also plays
an important role in reducing urban poverty. In fact, Sri
Lanka achieved very high levels of life expectancy and
low infant mortality rates by making social services
available to both urban and rural residents. The Indian
state of Kerala has an exemplary record of providing
social services. However, as the experience of both
Kerala and Sri Lanka demonstrate, such programs
cannot be sustained without rapid economic growth.
The government budget will not be able to provide the
resources because tax' revenues will not rise. Thus,
the targeting needs to be done very carefully.
DEALING WITH SQUATTERS One-third of urban
residents in Asia (Deolalikar et al.)--perhaps higher in
Africa and lower in Latin America-live in substandard
slums and squatter settlements. This means
households with ten or more people to a room, with no
permanent roof or walls, unsecure tenancy, and little or
no access to safe water and sanitation facilities. Many
governments have addressed the squatter problem by
building heavily-subsidized housing for the poor. While
this solution was popular with policymakers, the
desired social outcome-improved living standards and
poverty reduction in the urban areas-did not
materialize. The poor reacted differently from what was
generally expected. First, most of the poor could not
afford to maintain the property. Instead, these
properties were rented out to the non-poor who had
enough resources to rent and maintain it. The
experience in Manila, Jakarta, Bangkok, and other
Asian cities suggests that it is better to provide sites
and services, good drainage, some water and sewage
facilities, and security of tenure. The poor will then build
their own homes, usually slightly better than those they
had occupied in the squatter settlement. Finance for
house construction could also be provided but so far
there has been little success, mainly because the poor
are so poor that they cannot afford to pay any rental or
mortgage. This is the reason that they are living where
they do-paying no rent.
LAND USE More rational land-use schemes need to
be developed. In general, rent controls do not allocate
resources effectively and often result in the
deteriorating stock of housing because of poor
maintenance of rent-controlled properties. More
competitive markets that reflect land values for urban
land need to be established. Squatter settlements are
often in prime real-estate locations, yet resettlement is
difficult because urban infrastructure is often not
available to transport them into the city if they are
resettled. The cases of Bombay and New York are
instructive. In Bombay, a few people control much of
the urban land and as a result, little land is available for
accommodating the influx of immigrants from the
countryside. Thus, slums grow rapidly. In addition, the
cost of land has escalated and prices for all housing
have risen. In New York, rent controls resulted in many
landlords abandoning apartment buildings - it was not
economically viable to maintain them. As a result,
many blocks of flats in Manahattan and other boroughs
were left empty. And the land is valuable! Because of
the poor land policy, the land in both cities has been
inefficiently distributed and priced. To complicate
matters further in other cities in Asia, the military has
control over large sections of the urban landscape. The
Philippines and Thailand are good examples. These
two cities have terrible traffic congestion that could be
partially relieved if these large holdings were converted
to private use. Such a program has recently been
started in the Philippines.
END of LESSON
LEARNING CONTENT
Introduction:
In recent years, development economists have
begun focusing on human resources as a vital
component in stimulating rapid economic growth.
While physical capital and natural endowments of land
and resources are also important, human resources
play a critical role in bringing about the structural and
technological transformations that are required to
industrialize and raise per-capita incomes rapidly.
People, not machines, make the crucial decisions that
result in improved allocation of resources and the
implementation of new technology. They save and
invest in new technology and infrastructure, and also
decide how resources are to be used and mobilized. It
is therefore critical that these human resources be
developed and nurtured to ensure that they are
capable of making these important decisions.
Human capital is defined as human capacities that
raise productivity. Labor productivity increases in
particular are essential for sustained growth in the
economy. The improvement of human capital has
therefore become a prime objective in economic
development in many countries, including those in
Asia. The main channels of intervention are through
the provision of education and better health and
nutrition. A well-educated, highly-skilled and healthy
citizenry makes for a highly productive workforce.
Investments in human capital accumulation can only
lead to increased income and improved standards of
living.
Hence, the policy imperative for Asia is one of pursuing
economic growth and development alongside
continued investment in its people through the
provision of education and better health. Human capital
investments in health and education are an effective
mechanism for bringing marginalized groups into the
mainstream. Such human capital investment not only
provides people with better skills to participate in the
economy, but also gives them greater capacity to deal
with external shocks and to pursue choices that are
welfare enhancing for themselves and those around
them. There is widespread evidence that education is
one of the most prominent determinants of movements
out of chronic poverty. Health-related shocks, on the
other hand, push people into poverty. The growth
elasticity of poverty is another important consideration
in terms of the impact of growth. Empirical evidence
suggests that the impact of economic growth on
poverty is greater with higher levels of human capital.
For example, evidence from lndian state-level data
indicates that, although growth was associated with
poverty reduction, the extent to which poverty declined
varied substantially between states The higher the
level of public expenditure on development and basic
education and health, the greater the responsiveness
of poverty to growth (Ravallion, 2001, 2004).
This chapter focuses on how the Asian economies
have been able to undertake such investments and
how resources have been devoted to the task of raising
educational attainment and improving health to
complement the growth of physical capital and adapt to
a dynamic economic environment, both domestically
and internationally. We will also discuss some of the
issues and challenges faced by these Asian
economies in their efforts to provide health and
education services for their populations.
Lesson Proper:
THE ECONOMICS OF EDUCATION
Education can be defined broadly as any or all
forms of human learning. It can be formal, involving a
schooling system with a structured program, using
textbooks and having lessons within the confines of a
classroom. It can also be informal, where knowledge is
acquired in a very unstructured way, as children learn
from their parents and relatives, or through
apprenticeship schemes that teach a trade. Children
learn planting techniques and other skills in the fields
as they watch their elders, and eventually become part
of the agricultural community as a result of this kind of
informal training. In this chapter, however, we focus on
formal education, which has been the principal
mechanism for developing human skills and
knowledge over the past-few centuries. This is what we
refer to as education in this chapter. It includes primary,
secondary, and tertiary education.
A rapid expansion of the public educational system
occurred worldwide from the 1960s onwards, as
governments in both developed and developing
countries became convinced that the provision of
educational opportunities to the largest possible
section of the population was a critical component for
national development. Many countries in the
developing world made a commitment to provide
universal primary education and also to make a
sustained effort to spread education more widely at the
secondary level.
Several factors led to this approach. First, there was
mounting empirical evidence that educational
attainment and economic growth and development
were closely related. On a microeconomic level, this
was reflected by the high correlation between
educational attainment and earnings for a whole range
of occupations in many countries ( Psacharopoulos,
1994). It is no wonder then that governments have
been willing to spend a significant proportion of their
national incomes on public education. In the same way,
it is also not surprising that parents became more
willing to devote a larger part of their disposable
income to the education of their children. At the
macroeconomic level, it was reflected by a significant
relationship between increases in expenditure on
education and the level of educational attainment and
rates of growth in income in several countries
Furthermore, the developing countries were able to
observe that educational levels were much higher in
the industrial countries and that this was one reason
why they were able to continue to develop new
technologies and increase productivity.
Factors Affecting Spending on Education
Growth in demand for public education is partly
a result of growth in real income per capita. The income
elasticity of public expenditures on primary and
secondary education has been estimated to be around
1.5, suggesting that when incomes double, spending
on education will rise by 150 percent (Schultz, 1988).
The education process is labor-intensive by nature, but
studies have consistently shown that productivity has
not increased much in this sector. Additionally, there
has been a decline in teacher salaries relative to
average incomes in many countries. The low
remuneration has clearly helped to keep the cost of
education at the primary and secondary levels
affordable, but if the trend continues, the teaching
profession may in the long run find it difficult to attract This is a high ratio which is reflective of the young and
enough highly motivated and capable individuals. rapidly growing populations in these Asian nations.
Certainly, keeping the balance between the quality of These ratios in Asia are also high compared with those
teachers and the cost of providing education is a huge found in the more advanced economies of Europe and
challenge for policymakers. North America. Dependency ratios have gradually
decreased since then, owing to dramatic falls in
In the developing countries, the rapid growth of the population growth rates occurring over time. The
population has resulted in a substantial increase in the decline has been highest in the relatively richer Asian
number of school-age children. This has placed a countries, such as Korea and Singapore, as is evident
heavier burden on the carrying capacity of school in Table 11.1.
systems, which has resulted in split shifts, a reduction
in the expenditures per student, larger classes, and Table 11.1 Dependency Ratios for Selected
shared text materials in some cases. Given the limited Asian Economies
resources and the large demand for public educational
services in the developing countries, many conclude
that the quality of public schooling has deteriorated in
many of these countries in the past few decades.
In some developing countries, the shortfall in the
supply of educational services relative to demand has
led to the growth of privately funded schools. Some
policymakers favor such developments not only
because it takes the pressure off the public purse, but
also because many economists and policymakers
believe that a privately run school system is more
responsive to shifts in demand and other economic
forces than a public education system.
There is a risk, however, that a private school system
may perpetuate the maintenance of social elites as the
rich would send their children to better private schools Educational Spending
and the poor would have to be satisfied with an inferior Spending on education absorbs a much larger
public school system. As a result, in many developing
proportion of government budgets than most other
countries where private education has been allowed to
expenditures. It is thus important that we study the
flourish, this twin system of providing educational allocation of resources to this sector. The budget share
services to the population has led to inequalities in of educational expenses to GDP has steadily
“quality,” a dichotomy that continues into the provision
increased for most countries in Asia over time. In the
of tertiary level education. It also affects employment
1960s, the share of education in GDP ranged from less
outcomes as employers in such developing countries
than 1 percent in Nepal and Bangladesh to as much as
tend to favor graduates of private schools over their
3.09 percent and 3.74 percent in Singapore and Sri
public school counterparts. Lanka, respectively. By the mid1990s, the education
EDUCATION IN ASIA sector’s share in GDP averaged about 3.2 percent, with
Thailand and Malaysia standing out as having the
In most nations in the Asian region, the rapid largest shares of more than 4.6 percent of GDP, and
expansion of educational opportunities is seen as a key very comparable With those seen in Australia, Japan,
strategy toward sustained growth and long-term and the United Kingdom. In the 2002-2005 period, this
national development. Resources have, therefore, share of education continued to rise for many
been and continue to be expended so that enrolment countries, led by South Korea (its share increased to
rates are continuously improved and literacy rates 4.6 percent from 4.07 percent seven Years earlier), and
increased, in line with the general commitment of Malaysia (its share increased to 6.2 percent from 4.62
providing universal education in the shortest possible percent over the same period). The share of education
time. The country’s income per capita and its in Malaysia’s budget is now above those of the major
dependency ratio are the two important variables that industrialized countries, except for New Zealand, which
play central roles here. Per-capita income and had 6.5 percent share during 2002'2005 (see Table
dependency ratio jointly determine the educational 11.2). There appears to be a weak correlation between
attainment of the population at any point in time. In an increase in per capita income and a nation’s share
other words, these variables are the critical of the budget for education.
determinants of the economy’s ability to lift the average
educational attainment of its population.
The Population Factor
Economic growth and changes in fertility have
been dramatic in Asia in the past fifty years as we have
seen in previous chapters. An interesting aspect of this
dynamism has been the changing relationship between
the number of dependent or non-working members of
the population (those aged under 15 and over 65
years), and the number of people in the labor force
(those aged between 15 and 65 years). In the 19705,
the dependency ratio in Asia averaged about 51
(ranging between 46 and 56; see Table 11.1), that is,
there are about 51 dependents for every 100 workers.
 Table 11.2 Public Spending for Education as
Percent of GDP, 1960-2005
Trends in Enrolment Ratios
Looking at enrolment rates over the past fifty
years, a number of developments are evident
(see Table 11.5). Firstly, primary education has
become quite universal in most countries. However,
the quality of this education can vary substantially and
the figures in some instances seem high, since by
walking around in any of the major cities in South Asia,
it is obvious that the 100 percent figure is an over
statement. Furthermore, over aged students and
repeaters tend to distort the enrolment numbers at the
Primary level (see Table 11.6 for actual educational
survival rates from grade four to grade five). These
survival rates in education are closely related to levels
of per-capita income, suggesting that the efficiency of
education is highly correlated with income per capita
(see Figure 11.3).
Table 11.5 Gross Enrolment rates by Level of
Schooling
Table 11.6 Survival Rates in Primary School
Figure 11.3
The data in Table 11.5 also show that the NIEs started
in 1950 with a very strong primary education base but
so did a few other countries such as Sri Lanka and the
Philippines, which now have much lower per-capita
incomes. We have noted this in earlier chapters and
speculated on the reasons that they were not able to
capitalize on a strong primary education base, as did
the NlEs. Bangladesh and Pakistan, on the other hand,
stand out as countries that have made little progress in
education generally. Note that right after World War II,
there was much less disparity in per-capita incomes,
but the gap has increased over time. Could the
divergence in income in subsequent decades be
partially the result of a stronger commitment to
education by the NIEs?
Rates of Return to Education
Table 11.7 shows the rates of return to
education in Asia culled from a number of separate
studies, as reported by Mingat and Tan (1992). As
expected, the returns are higher for primary education
and lower for higher levels of education. However,
these results do not show the intrinsic value or merit
good of education that would be reflected by higher
social rates of return vis-a-vis private rates of return.
Perhaps this is because the countries examined for
which both rates of return were calculate are at the
poorer end of the income scale. It may also be that
tertiary education is not considered a merit good.
Table 11.7 Rates of Return to Education
Another recent study by Cohen (2002) compares the
rates of return to education together with experience.
The approach follows that originally developed by
Mincer (1974). The rates of return to education in Asia
are nearly identical to those in the United States for the
period of the 1980s and 1990s, at just under 10
percent. The returns for the first year of experience are
somewhat higher in Asia-about 4 percent versus 3
percent in the United States. This study also concludes
that the rates of return in poor countries have risen in
the past few decades, contradicting the conventional
wisdom that poor countries would experience a decline enrolment in the school. This is true for both secondary
in returns to education as globalization raises the and tertiary education.
demand for low-skilled workers in these countries.
Rather, the openness to globalization raises the Figure 11.4
returns to education in the poor countries since the flow
of technology enables many of them to begin
manufacturing skill and capital-intensive products that
require more highly skilled and educated labor.
Gender Disparities in Educational Attainment
Gender disparities exist at all levels of
education for most countries, but they tend to fall as
incomes rise, as do literacy differentials. Only the
results for South Asia (such as Bangladesh, India, and
Pakistan) show a highly skewed pattern of
discrimination against women. A Similar skewness is
observed in the girls-to-boys enrolment ratio, by the
level of schooling, as shown in Table 11.8 although in
several Southeast Asian countries, such as Malaysia
and the Philippines, the enrolment rate for tertiary
education has been higher for females than for males. The proliferation of private schools, however may
exacerbate existing income and wealth inequities
Table11.8 Girls-to-Boys Ratio by Level of within an economy. Poorer families tend to send their
Schooling children to public schools, while more affluent families
send their children to private schools. While there are
economically justifiable reasons for allowing private
education systems to flourish, this dichotomy drives a
wedge between graduates of “public” and “private”
education systems, and does affect labor market
outcomes as employers tend to favor graduates of
private schools more than their public-school
counterparts.
Teacher’s Pay, Class Size, and Educational
Efficiency
There is also evidence that efficiency improves
as the student-to-teacher ratio increases up to a point.
GENERAL ISSUES IN EDUCATION POLICY A study by Leroy (1995) shows that the pupil-teacher
ratio does not have much effect on educational
There is no doubt that education plays a very outcomes when the range is 25 to 50 pupils per
important role in the economic development of nations. teacher. At the same time, the pupil-teacher ratio tends
We have outlined above some of the important aspects to decline with higher income. Therefore, it may be a
of education provision, but there remains much more good strategy for poorer countries to increase class
to say. In this section, we discuss a few other important size while improving teacher quality. As incomes and
issues that are directly relevant for policymakers. education budgets increase, they can gradually reduce
class size.
Greater Privatization of the School System
Surprisingly, teachers’ wages are not highly correlated
An argument can be made for greater
with the level of economic development.
privatization of the school system by allowing private
schools to coexist with public schools. This gives The NIEs have also performed very well in
students greater choice and also helps to promote internationally standardized tests administered in a
competition between public and private schools. A number of industrial and developing countries (see
study of the Philippines by Jimenez (1987) shows that Tables 11.9 and 11.10).
administrators in private schools who are financed by
local funds have greater incentive to minimize costs Table 11.9 Scores on Internationally Administered
while maintaining quality. The provision of a private- Competence Tests
school alternative also helps to reduce the budget
burden on the public purse as a result of these
competitive factors. For example, in Asia as a whole
the index of private-school financing and the index of
costs per capita for higher education are inversely
related (see Figure 11.4). However the curve flattens
out at about 40 percent financing. Perhaps there is a
range of funding for tertiary education by the private
sector of around 50 percent. At higher rates of private
financing of higher education, the social selectivity of a
totally privately funded hi her education system will
work to exclude the poorer segments of society.
Studies in the Philippines and China also show that the
unit cost of education tends to fall with the size of
 Table 11. 10 Science and Mathematics Average
Scores at Age 14
A tentative conclusion that can be drawn from the
above results is that the strategy followed by the NIEs
to pay higher wages to teachers and to have larger
class sizes led to more efficient education. Higher test
scores in Korea and Singapore reflect this. Whether
such a strategy would benefit other countries would
have to be studied carefully because of the differences
in local conditions. However, prima facie, it seems to
be a good starting point for reform. In Indonesia,
Thailand, and the Philippines, the results of
internationally administered tests were less
satisfactory, providing further evidence that the
approach followed in East Asia has been more efficient
and productive.
Quality versus Quantity of Education
The rapid increase in demand for educational
services has been based on the notion that having
more years of schooling is more likely to boost one’s
earnings in the labor market. Furthermore, there is
some evidence that past a certain threshold of income,
there is bound to be greater substitution between the
quantity and quality of education obtained. How much
of the variation in earnings is a result of quality
differences? A related point is the family background of
the student. It is important to recognize that all three of
these variables are probably highly correlated in most
samples-that is, higher quality, higher quantity, and
“good” family background tend to go together. Thus,
the returns to education have to be interpreted
carefully. Simply offering to extend the same quality of
education to a wider cohort will probably give a lower
rate of return than estimates based on data where all
three variables are changing over time. This is because
some of the increase in wages/earnings will be
attributed to the increase in quantity of education,
whereas the quality of education and the background
of the student will also be important determinants of
earnings on their own account. Moreover, studies
conducted with panel data suggest that a pupil’s home
environment and social status are much less important
in developing countries than it is in developed
countries. These studies also show that the variation in
academic achievement attributable to factors internal
to the school system, such as the physical
infrastructure and facilities, the quality of the teachers,
and the availability of books, and other teaching
materials and facilities, play a much more important
role in the developing world than it does in developed
countries. Despite these caveats, there is still a strong
economic and social incentive to invest in education.
These findings also reinforce the conclusion that
greater emphasis should be put on providing good
facilities and teachers.
Tertiary Subsidies and the Brain Drain Problem
Tertiary education tends to be much more
costly relative to primary education in developing
countries than it is in developed countries. For
example, tertiary education per pupil in India costs 50-
100 times more than that for primary education (Mingat
and Tan, 1992). The wage differentials between the
tertiary graduate and those who obtained less years of
schooling tend to be higher in developing vis-a-vis
developed countries. It was also pointed out earlier that
the external benefits of education diminishes with more
years of schooling-that at higher levels of education,
greater benefits accrue to the individual more than to
the society. This reality must be recognized by
policymakers in developing countries where large
subsidies are often given to higher education, which
tend to have a regressive effect on the taxation system.
An associated problem is the phenomenon called
“brain drain” (see Box 11.1). When higher education is
subsidized and there is international labor mobility,
there is likely to be a larger “brain drain” problem. This
wastes public resources and indirectly provides a
subsidy to the richer country, which does not have to
spend on training for the immigrant. The solution is to
reduce the subsidy to higher education dramatically.
MORE ON THE ”BRAIN DRAIN” .It is generally
observed that the better educated are the most likely to
migrate. In the early stages of development, rural to
urban migration is more attractive to the more educated
agricultural workers. This is because real wages are
generally higher in the urban areas. This increased
tendency to migrate occurs not only within national
boundaries, but also internationally. This is
exacerbated by a situation where there are too many
highly educated citizens who cannot find employment
locally that is commensurate with their qualifications.
These issues are discussed further in Box 11.1.
Inequality Effects and Missing Credit Market
The educational levels and quality of education in Asia
vary widely among countries. The policies that an
individual country follows at a particular time will
depend upon the status of the existing system. In many
instances, the existing system tends to perpetuate the
education of the ruling class and discriminate against
the education of “gifted” poor children, particularly in
rural areas where hunt for primary education may be
weak.
A balance needs to be struck between the different
objectives of a subsidized education. If there is great
inequality in the redistribution of income, more
generous subsidies may be given to gifted students,
even at the tertiary level. In a comparative study of
Kenya and Tanzania, Armitage and Saba (1986) found
that higher school fees in Kenya resulted in a higher
secondary enrolment. This could have helped Kenya to
achieve more rapid development than Tanzania, which
followed a policy of keeping secondary education free
but reduced enrolment by test screening. To
understand how these policy issues apply in particular
countries, we have to understand the existing
educational system in these countries and assess the
quality of the education provided.
One way to address the inequalities raised above is
through the development of a well-functioning credit
market. Low levels of wealth hinder or even bar
productive educational choices because of the failure
of credit markets. For the poor, educational loans are
difficult to obtain because of a lack of collateral. In India
and Thailand, there seems to be a working credit
market for education-but it may still be inaccessible to
the poorest income groups.
Implications for Policy Based on the above analysis, we
can draw five tentative policy conclusions:
1. Curbing population growth means lower
dependency rates and increases the ability of
the society to educate its population with the
same resource base.
2. It pays to educate teachers more intensively
and to pay them well, even at the expense of
having slightly larger classes.
3. It is advantageous to spend on education for
girls and primary education in general
investment in these areas shows high payoffs,
both in social and private returns.
4. It pays to encourage private providers of
tertiary-level education and possibly at the
secondary level as well if they do not already
exist.
5. Experiments with higher pupil-teacher ratios
and decentralization of authority over school
management, the curriculum, and the budget,
may also be advantageous.
HEALTH AND ECONOMIC DEVELOPMENT
Health is a very important component of
development. Ensuring the general health of the
people around the world is the overriding concern of
international agencies such as the World Health
Organization (WHO). Understandably, there are
personal gains from having good health but
organizations such as the WHO and national
governments also recognize that the general health of
the citizenry is an important element in national
development.
In this module, we define health as the overall well-
being of an individual. This definition covers the
physical, mental, and social state of the person and is
essentially the definition used by the WHO and other
international agencies. In simple terms, health means
the absence of illness and infirmity. That said, there will
be instances when we use “health” to refer to the
general well-being of the population. In this context, we
talk about morbidity and mortality rates, which refer to
the chances of a person becoming sick or dying
(presumably due to illness), respectively. The former is
a difficult statistic to measure, as trips to the doctor are
the only available information that can be used to
estimate this probability for the population. However,
not everyone sees a doctor when they fall ill. In the
developing countries, this problem is worse since
access to medical services can be remote. The
measurement of morbidity may also be complicated by
the gravity or seriousness of the illness being reported.
In contrast, mortality rates can be and are more closely
monitored. In most countries, the national statistical
agencies maintain databases of births and deaths in
the economy, and their regular publications contain
these statistics for the year. Statistics on the causes of
death also provide important clues to the general well-
being of the population and, as such, can be used to
form another set of health measures. Unfortunately,
these sets of information are not always available or
reliable.
Other statistics are also commonly used, such as infant
mortality, life expectancy at birth (number of years a
person is expected to live), crude birth rates and, of
course, crude death rates.
A healthy population is an important ingredient for
economic growth and development. Good health
increases the worker’s strength and stamina and
enables him/her to work longer hours and concentrate
more effectively. There is little argument that a healthy
and fit workforce is better able to increase national
productivity. Good health is also known to improve the
performance of children in school. When children are
well fed, they tend to have a longer concentration span,
absorb what is taught more effectively, and are
generally able to participate better in class activities.
Besides increasing the quantity and improving the
quality of human resources, health expenditures can
also extend the availability or productivity of non-
human resources. The clearest example is the large
tracts of land rendered inhabitable or unusable by
endemic diseases. Malaria and typhoid fever blocked
access to many parts of Latin America, Africa, and Asia
before these diseases were brought under» control in
the twentieth century. Even today, schistosomiasis
makes it unsafe for people to enter lakes and streams
in sections of Africa, and trypanosomiasis (an African
sleeping sickness) restricts the range of the livestock
industry. So far, no chemical means of control have
been discovered for either of these diseases. China,
however, has made progress against schistosomiasis
through mass campaigns aimed at ridding lakes and
streams of the snails that transmit the parasite. The
success of such efforts can substantially enhance
productivity and increase the amount of arable and
habitable land.
Aspects of Health in Developing Countries
While the good health status of the population
is essential for economic growth and development, the
pursuit of good health for every citizen is an important
goal in its own right. It must be recognized recognize
that decisions to invest in health should not primarily
depend on whether it has high rates of economic
return. Good health increases the human potential in
all areas and is rightly regarded as a basic human
need.
In this section, we discuss three main aspects in the
context of their implications for policy: (a)
environmental health; (b) malnutrition and food
consumption; and (c) medical services.
ENVIRONMENTAL HEALTH One effective approach
toward better health outcomes in deve10ping countries
is through the improvement of environmental
sanitation. In many developing countries, the spread of
infectious and parasitic diseases can be effectively
controlled by ensuring that people have access to
clean water and the provision of an adequate waste
disposal system. Experience has shown that such
measures have effectively controlled the spread of
waterborne diseases such as typhoid, dysentery, and
cholera. Improving housing conditions-with better
ventilation and space-can also minimize the spread of
tuberculosis. Health risks for these diseases are
exacerbated by the presence of urban slums,
especially in developing countries. These are pockets
within a city that are highly populated by the poor and
housing conditions are very cramped.
MALNUTRITION AND FOOD CONSUMPTION A
person suffers from malnutrition if his/her food Intake
does not meet minimal nutritional requirements for the
physical body’ to function well. In most developing
countries, malnutrition simply means not having
enough food to eat. It is a major cause of ill health and
premature death. Having the right amount and kind of
food for the young is very important as they are still
growing Inadequacies in their diets affect their physical
and mental development and this will affect the quality
of the adult population in the future.
What causes malnutrition and how can nutritional
improvements contribute to economic development?
The consumption of food, like any other goods or
services, is determined by three elements: income,
prices, and tastes.
Income
Engel’s law says that poorer households devote a
greater proportion of their budget to food and that
they have a relatively high income elasticity of
demand for food. This means that any additional
income will be used to purchase food for the
household. At higher income levels, the budget share
of food declines in favor of other goods and services.
Income, therefore, is an important indicator of food
consumption levels, particularly at lower levels of
household income. There is, nonetheless, recent
research showing that an increase in income is not a
guarantee that the general calorific intake of the
population will increase because of the substitution
effect that occurs-substitution for tastier, better
quality, or wider variety of food, rather than on more
calories.
Prices
There is a much evidence accumulated from
household studies showing that the poor are very
sensitive to changes in the prices of a food basket
and they tend to make strong substitutions when
prices change. How does this relate to the nutrition
content of this food basket? If we derive a demand
function for nutrition rather than the food bundle itself,
a number of unexpected conclusions can be drawn
from the literature. This happens because of strong
cross-price substitution effects among different foods
together with variations in nutrient-to-food
conversion ratios. For example, if the price of rice
increases, we would expect the nutrition content of
the diet of the poor to decrease, other things being
equal. However, what happens is that there is a
sufficiently large increase in the demand for other
relatively nutritious foods to offset the decline in
nutrition resulting from the fall in rice consumption.
A related point is the response of the poor versus the
rich to price changes. Own price elasticities are much
higher for the poor than for the rich (for cereals, close
to negative one for the poor, and near zero for the
rich, according to one study). Within households,
female children are generally made to accept a
greater nutritional burden of adjustment when there
are unfavorable price movements. The nutrition of
others in the family moves much less.
Taste
Cultural beliefs and tastes in the consumption of
particular types of food can impede nutritional
improvement. Many traditional societies have beliefs
about the health effects of various food5 that are not
supported by modern nutritional science. More often
than not these beliefs can be harmful to the health of
certain segments of the population. Soybean
products, for example, have been found to be a
cheaper source of protein than animal products yet
their potential as a primary provider of this much
needed nutrient in the household diet is yet to be fully
exploited in the poor countries of Africa or South
Asia, where meat is still preferred.
MEDICAL SERVICES Medical facilities and services
in the developing countries are very inadequate in
providing for the health needs of the growing
populations. Table 11.14 shows indicators of health
care facilities for selected countries in the Asian region
for percentages of populations with access to health
care). For a start, public expenditure on health in
developing countries has always lagged behind those
for education, defense, etc. Furthermore, compared to
developed countries, these health expenditures are
very low, even as a percentage of GDP (see Table
11.15). This has resulted in a stock of medical
resources-facilities and personnel-that are far from
adequate for the needs of the population. There are
usually long queues in the few established health
centers, insufficient medicine supplies, and a lack of
trained health personnel to support these services. The
number of physicians willing to practice in the public
sector is also limited because many doctors are lured
by the prospect of higher income in private practice.
Table 11. 14 Health Care Facilities in Selected Asian
Countries, 2000
Table 11. 15 Public Spending on Health as Percent of
GDP, 1990-2005
In addition to inadequate supply, health services in
developing countries are also unevenly distributed with
large urban-rural differentials in the quality of services
provided. On the one hand, there is a strong drive to
acquire the latest medical technology to make the
domestic capacity comparable to Western economies.
Thus, much is spent on medical machines that support,
for example, open-heart surgery. This usually happens
in the cities, where the interests of the urban elites are
satisfied. On the other hand, rudimentary medical care
to sick infants and children is woefully inadequate,
particularly in the rural areas of the country.
In addition, the developing countries spend far more
resources on curative health care when it is well known
that preventative health care is the more sensible
approach.
PUBLIC-HEALTH POLICIES AND THE ASIAN
EXPERIENCE
The World Health Organization’s Commission
on Macroeconomics and Health released an
assessment of the health conditions in developing
countries in 2001 (WHO, 2001). Among their findings
were that mortality rates for children under 5 years old
in the poor economies (under
US1,000per−capitaincome)arenearlytwentytimeshigh
ervis−a−vistheratesinthericheconomies(overUS20,000
per capita income). The report provides strong
evidence that better health raises the productivity of
labor and the level of wages, and that as health
improves and wages increase, the health of women
also improves, which in turn results in better health and
education outcomes for their children. In the end, the
report recommends greater investment in the health
programs because improved health definitely promotes
more rapid growth.
The experience of the developing countries in Asia
supports these conclusions. Table 11.16 compares the
rates of growth in real per-capita income between 1965
and 1999, with different initial per capita incomes and
initial infant mortality rates (IMRs) for 1965. These
comparisons show that much higher rates of growth
were achieved by countries with low IMRs in 1965 than
by those with high IMRS (5.4 percent versus 1
percent).
Table 11.16 Growth Rate in Per Capita Income(1965-
1999). . .
Subsidies and Nutrition
There appears to be a mismatch in the food
products that are subsidized and those food products
that the poor consume. Studies have shown that
meats, poultry, and dairy products have been given
some subsidies in several developing countries.
However, these products are too costly for the poor to
consume. If subsidies are to be given, they should be
for grains such as rice and wheat, which are most
heavily consumed by the poor.
Raising Incomes through Direct Transfers
Raising incomes through direct transfers does
not necessarily improve nutrition and health while this
point is still being debated, there is some evidence that
the income elasticity of nutrition expenditures may be
very small in some countries. In these cases it may be
better to provide direct nutrition through a subsidy to
augment programs to raise the incomes of the poorest
and most deficient groups.
Macroeconomic Effects
It is difficult to assess how macroeconomic
adjustment policies have affected nutrition and health
outcomes. The evidence for adverse impacts is not
strong. However, when economic growth falters for a
prolonged period, the health effects can be
catastrophic. The experience of Russia in recent years
is a case in point. An analysis of the impact of the Asian
financial crisis on health may also provide some useful
insights as to how public policy can be improved in the
areas of health provision and services. Preliminary
results suggest that it may have more to do with the
failure of the government’s health and delivery system
to react promptly to the crisis than with specific policies
relating to health.
Charging Fees for Health Care
It has been discussed earlier that health care in
developing countries is severely under-financed.
Prices have generally played a minor role in generating
resources for financing health services or in
determining those who have access to them (Jimenez,
1987). According to recent estimates, only 7 percent of
the cost of publicly provided health services in
developing countries is currently recovered through
user fees. This has led to proposals to increase the
fees charged for health services and to institute
charges for those who are provided with free medical
care. The revenue generated would be used to expand
health services.
Jimenez (1987) recommends that we account for
externalities generated by each type of health service.
If the externalities are large-that is, when society
benefits significantly from the provision of one unit of
service to an individual or a household-then this type of
health service must be provided below cost. However,
if the benefits from a particular health service accrue
mainly to the individual in other words, when the
externalities are low-then the cost for this type of
service should be borne by the individual. Broadly
speaking, one will not want to charge fees for
preventative health care services, but one will want to
charge a reasonably high price for curative health care.
If there is excess demand on these high-priced
services, then prices can be further increased. The
revenues generated can then be reinvested in
expanding services. If there is no excess demand
generated, then the effect of a fee increase on
revenues and the level of services provided would
depend on the elasticity of demand for health services.
Available evidence suggests that this demand is highly
inelastic, since some people regard some services-
particularly curative services in health emergencies-as
necessities. Jimenez notes, however, that user fees for
the highest cost services can be brought close to the
cost of providing them only if medical insurance is
widely available, since few of the people unfortunate
enough to require such services are able to afford
them.
In the context of a developing country where most
households and individuals are not able to afford
primary health care for themselves and their family
members, it is an uncomfortable thought that people
will only be provided with medical and health service if
they can pay for some, if not all, of the cost of the
service. More often than not, those who use public-
health services are the poor. Instituting charges for
currently free services will not matter much to the rich-
they simply do not use them-but it will affect the poor
greatly. In terms of policy, governments should devote
more resources to preventative care and improving
environmental health so that morbidity rates,
particularly among the poor can be improved. If and
when this happens, demand for preventative health
care services can be used.
*** END of LESSON ***